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Is it the end of cash for SMSFs?

Falling SMSF cash balances over the past five years are tipped to accelerate on the back of new COVID-19 challenges, as interest rates look set to stay lower for longer.

These interest rate declines dominated the headlines for SMSFs during 2018 and 2019, as many trustees reconsidered their investment strategies. The average SMSF reduced its cash balance by 6% in the five years prior, according to the September 2019 data from the Australian Tax office. SMSFs are certainly looking for alternatives.

Challenges for SMSF portfolios

Then came COVID-19 and its associated challenges, including falling share dividends and uncertain property and rental markets. This has placed further strain on SMSF cash flows and is expected to lead to a wave of diversification as trustees seek to prop up reduced cash flows.

In the recent company reporting season, SMSFs were hard hit by announcements from Australia’s big four banks that dividends were being reduced or suspended – a move that is expected to be mirrored in other key industries including airlines, hospitality and tourism.

Historically, the strong dividend programs of Australia’s blue-chip companies have proved lucrative for SMSFs, reducing the incentive to consider other investment avenues. Unfortunately, it has also led to portfolios being too concentrated and subject to shock from unforeseen events.

Continued market volatility coupled with the flow-on effects of COVID-19 and rock bottom interest rates has Australia’s wealthiest SMSF investors actively seeking opportunities outside of the traditional asset classes.

When savvy SMSF investors consider how they want their portfolio to perform, they don’t just think about returns. A key consideration is the ability to be able to withstand unexpected market events.

Why are SMSF investors turning to fixed income?

We have noticed an increase in SMSFs wanting to lock in returns and reduce risk. These factors are driving a renewed focus on income options like corporate bonds and tailored investments, which offer investors access to equities in a structure that can reduce risk, and which provide an agreed rate of income upfront.

During the first quarter of 2020, we saw a 44% year-on-year increase in bond transactions and a 73% increase in tailored investment transactions. 

(Tailored investments are also known as structured products, as they typically pair a bond and a share or basket of shares to form an income-bearing product with exposure to equity markets).

SMSFs have traditionally been underweight in fixed income, although it tends to be more resilient during times of market volatility. Adding fixed income to an equity portfolio can reduce the unpredictability in portfolio returns without overly hindering performance.

It is also a source of reliable income, because interest payments are guaranteed by the issuer and paid regularly – assuming the company doesn't default. Our clients focus on investment grade local and global companies, with strong balance sheets and a track record of performance and risk management.

Foreign currency and risk management

Another key trend we have observed is a significant increase in foreign exchange transactions, up 77% in the first-quarter 2020 versus the same period last year.

This foreign exchange movement has primarily been into US dollars, for the following reasons:

  • to take advantage of the currency's safe haven status,
  • a belief that the recent Australian dollar rally may not be sustained as long as uncertainty remains the norm.

For SMSFs, investing outside of Australian-denominated assets has not been a widely-utilised strategy. However, investors who hold positions in foreign currency are able to access a wider range of hedging and diversification opportunities.

The simple message to diversify is not a new one, but it is one that has not sunk in for thousands of trustees within the SMSF space due to the appealing lure of equities and dividends.

While COVID-19 presents many challenges, one positive may be that it encourages SMSF investors to look to new investment strategies and investigate the benefits of diversification across asset classes.

 

Leonie di Lorenzo is an SMSF specialist at Citi Australia, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any individual.

For other articles by Citi, see here.

 

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How bonds may temper equity market disappointment

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