In May, when the Reserve Bank of Australia cut official interest rates to the historically low level of 2 per cent, most attention naturally focused on the impact the cut would have on the cost of repaying a mortgage.
Some, but considerably less, attention was paid to the impact on investors relying on income from interest-bearing investments. The impact on this group of people has been profound, and in some cases devastating.
Since August 2008, interest rates have fallen from 7.25 per cent. The chief investment officer of ipac funds in AMP’s multi-asset group, Jeff Rogers, notes that since November 2011, when the current cycle of easing began, rates have fallen by some 2.75 percentage points.
While that is great news for anyone struggling to pay off debt, Rogers also notes, the income from term deposits (TDs) is now less than the rate of inflation. In other words, even though their capital remains secure, investors in TDs are experiencing negative real returns.
Download the full In Focus feature, “Re-examining investors’ options for income”, as a PDF.
A fall in interest rates often has the effect of encouraging investors to seek alternative sources of income. This is where careful guidance and advice can pay off spectacularly, if it helps these investors achieve their income needs without exposing themselves to unnecessary and unintended risk of capital losses.
But investors need to carefully – and on some suggestions, literally – consider their options when it comes to looking for new sources of income.
Using an option to generate income
The Zurich Investments Equity Income Fund, managed by Denning Pryce, actively uses options strategies to seek additional income for investors. It invests primarily in a portfolio of shares drawn from the S&P/ASX Top 50.
Patrick Noble, a senior investment specialist with Zurich, illustrates how a strategy selling options can generate income for a portfolio.
“Back in March, AMP was enjoying quite a nice run leading into its dividend, and paid 13.5 cents a share on March 3,” Noble says.
“The fund sold a call option just after AMP went ex-dividend. While the fund gets the 13.5c dividend, it also found a good opportunity to sell a call option. We received 18c for selling a May $6.75 AMP call option. AMP was trading around about $6.50 at the time.
“Effectively, we’d be happy for someone to come and knock on our door between now and May and say, I’m going to buy your AMP shares from you for $6.75. The fund has locked in some upside…but then got a further 18c from selling the option.
“So really we’ve generated 18c in income and the potential of up to 25c in capital growth, to $6.75, over a two- to three-month period. And if we were to get exercised, the break-even is actually $6.93 – the 18c plus the $6.75.”
Noble stresses that the AMP trade is an example of one that has worked well for the fund. Not every options trade will pay off as well; but as with many things in funds management, the key is to get things right more often than not.
In this example, Noble says that “if nothing else happens, the fund generates an annualised income in excess of 10 per cent”.
“If we do get exercised the annualised return is closer to 30 per cent. We think that’s a pretty reasonable trade-off,” he says.
“It just so happens that AMP is trading at about $6.60 and the option expires on May 28. While there’s a couple of weeks left, it’s trading well below the strike price providing a nice return from the income.”
