Market downturns create opportunities for investors

The rapid deterioration in market sentiment over the past months has been well documented in the media.

But it is times like these when opportunities often arise for investors. By being prepared to take a measured approach to risk within an appropriate timeframe, I believe value is starting to appear for investors seeking income.

In the first half of 2008, the Australian economy remained resilient to the global economic slowdown. This period was a prelude to a worsening global credit crisis, the fallout from failing equity markets and a massive reduction in investor confidence.

In the second half of 2008, the flight to the relative safe havens of cash and term deposits came as no surprise. The cash rate was around 6 to 7 per cent, and term deposits were yielding 6 to 8 per cent — not bad returns in retrospect.

As we moved forward into the second half of the year, the Australian economy began to feel the effects of the global crisis.

In response, the Reserve Bank of Australia slashed the official cash rate, by 4 per cent over a five-month period to the current 3.25 per cent; in effect slashing six years of rate rises.

Interestingly, the premium between the cash rate and average dividend yield of the Australian stock market has changed dramatically throughout this period. In the first half of 2008, the average dividend yield was trading at a discount to the cash rate — which is to be expected over the long term — to be trading now at a significant premium.

This is an indicator that value is now appearing.

Most market commentators would probably acknowledge that the current historically high average dividend yield is unlikely to continue going forward.

What is up for debate, however, is the degree to which dividends of Australian companies may be cut going forward.

The simple point here is that even if the average dividend yield drops by 30 per cent, for example, a tax effective income stream via shares is currently attractive over the long term.

Trading in fixed income markets in the 2008 calendar year has been as dramatic as that seen in equity markets. The escalating crisis resulted in a ‘flight to quality’ in US Treasuries, especially shorter-term maturities.

By the end of 2008, all the major global markets were trading at or near their yield lows. Yield curves globally also steepened in response to the aggressive central bank rate cuts. Credit-based fixed interest investments suffered in the wake of a flood of sentiment away from risk.

The market savaged some of these investments, driven primarily by a lack of liquidity rather than a stream of defaults.

This in turn saw a rush to exit the market and a stream of hybrid/high yield funds becoming illiquid in Australia, which in turn contributed to some fund freezing redemptions. The mortgage sector, for example, effectively shut down for business.

The issue here is not so much about the risk of default but more about a lack of liquidity.

In 2007, our research highlighted the risks of the hybrid and high yield fixed interest market. The message at the time was the importance of an awareness of risk and return.

In November 2007, yields on offer were thin in some areas due to tight credit margins, especially when compared to what is on offer now. Arguably the pendulum has swung too far, and highly rated investment grade securities for some investors now appear attractive from a risk and return perspective.

The other key message in 2007 was diversification. This remains the message going forward for advisers looking for the solution to the fixed interest portion of their portfolios.

With limited mortgage funds and a reduced number of high yielding credit based fixed interest funds also now suspended, it may be worth looking at diversified income funds for a strategic allocation to the defensive part of your portfolio.

These funds also continue to look attractive relative to cash from a yield perspective, especially those that include duration management, government or sovereign bonds mixed with some highly rated investment grade credit.

It should be acknowledged that bonds have had a great run at the expense of credit throughout 2008, however, for the anchor of your portfolio you should continue to consider both.

Who knows where the cash rate will end in 2009?

My guess is that this decision is best left with a fund manager. Importantly, diversification across sectors and securities, together with a good understanding of the drivers of risk for the range of funds available, both in rising and falling markets, will hold investors in good stead.

What is also important is to keep it simple, as even the most sophisticated investment strategies have come unstuck.

Products that may be suitable for this type of strategy are typically diversified income products that include a mix of duration management, bonds and highly rated investment grade credit.

Each fund will have a different mix, and the right fund for a particular client will depend largely on the preference and tolerance for risk.

If a client is chasing returns rather than focusing on diversification for the equity component of their portfolio, an investment grade credit type fund may also be worth considering over the medium term.

Stuart Fechner is distribution development manager, investment product, at Aviva.