Shane Solly: Yield junkies need to face reality

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New Zealanders don't ask for enough return on some investments and ask for too much on others.

This means that the New Zealand capital market is both unusual and stunted when compared with the capital markets of other similar sized economies. The way in which New Zealand investors approach income- producing securities contributes significantly to the problem.

New Zealand investors don't seem to have learnt anything from the recent finance company debacles. In some cases, there were no lessons to be learnt as taxpayers bailed out risk-seeking investors. In other cases, people lost capital that they did not need to lose if they had fully considered the true risk they were taking on.

Investing in income-producing securities is a great way for investors to maintain the purchasing power of their savings against inflation, generate a modest risk income stream to complement other income streams and, in some cases, to increase wealth via capital gains.

New Zealand investors have been historically drawn to securities which pay a high income stream, often without fully understanding what investing in these securities means.

Not all investment income, or yield as it is also known, is equal. Financial engineering can artificially enhance near-term income streams at the risk of medium-term capital protection.

Investors need to understand how and where the income stream is being generated and how risky or otherwise the generation of that income is.

This doesn't mean not investing in income-producing securities that have a high-risk earnings source, it just means investors need to make sure they are getting paid enough or are buying the security cheap enough to compensate for the potential of the income not being delivered and/or their capital not being returned.

Before investing in a high-yield investment, people need to ask themselves:

* Am I investing for capital protection or regular income?

* If for capital protection, is this investment going to return my capital and protect my purchasing power against inflation?

* What's the potential of not getting a full return of capital?

* If it is for regular income, is there a lower risk way to deliver my required yield?

* Are the nominal yield and the yield margin above lower risk assets enough to compensate for the risk of not getting all or some of my capital back?

* Does my timeframe allow for the fact even income-producing asset prices go up and down in the near term?

* Rather than investing in one or a small number of high yielding investments, could I create a better outcome for myself by holding several assets with limited capital-loss potential and several assets with higher risk that provide longer-term growth and inflation-protection potential?

The New Zealand PIE (Portfolio Investment Entities) tax regime means that for many resident taxpayers they may be better off by effectively generating income by selling units in PIE-compliant securities on a regular basis rather than depending upon interest income paid by high-yield investments.

Given how low interest rates are at the moment, investors need to be wary about investing in securities that offer only a marginally higher return above low risk investments, such as bank deposits, while the underlying risk of the higher-yielding security is greater than the low-risk investments.

Investors need to remain vigilant. Once they have invested in high-income securities, they need to keep monitoring the investment to make sure the underlying business has not deteriorated and its ability to pay the expected income stream is not impaired. Where income or capital is at risk, investors should reconsider their investment in high-income securities relative to alternatives.

Yield junkies beware - as the old adage states - if it looks too good to be true, it generally is. Invest in more than one asset class, own multiple securities in the asset class and don't be greedy - a reasonable return is better than none.

- Shane Solly is a portfolio manager at Mint Asset Management.