By Graeme Colley
Executive Manager, SMSF Technical & Private Wealth
The predicted ongoing increases in interest rates have sent shivers down the spines of many SMSF trustees, but should they be concerned? The answer depends on the factors unique to each SMSF, including the fund’s investment strategy and its investment mix.
The investment strategy of all superannuation funds, including SMSFs, is required to consider:
• the risks and likely returns from investments,
• cash flows,
• investment diversification,
• liquidity, and
• the ability of the fund to discharge existing and prospective liabilities.
All these requirements are closely linked and can turn out to be a bit of a balancing act when markets are volatile. It is up to the trustees to implement and maintain a portfolio of investments consistent with that strategy as it changes over time.
As a general rule, an investment portfolio of an SMSF may consist of:
• listed and unlisted shares and units in unit trusts,
• commercial and residential property,
• term deposits, and
• specialised and boutique investments.
If we apply the requirements of the fund’s investment strategy to an increase in interest rates, we may see increases in the value of some investments and decreases in the value of others. Under these conditions, some investments may provide higher income and capital gains while others may provide less. This volatility may upset the balance between those investments which have been acquired to produce capital growth while others are for purposes of income. The capital growth and revenue components of the fund’s income may vary. This may alter the fund’s cash flow and liquidity and may impact the fund being able to pay expenses and other liabilities.
Let’s look at the possible changes to the major asset classes – cash, fixed interest, equities and property and how they react to interest rate changes as a general rule.
An increase in the interest rates on cash is usually influenced by greater demand for money in the economy. This may result in the fund placing any cash it receives from dividends, interest or rent into interest-bearing cash deposits, which are highly liquid. Where interest rates are rising at a rapid rate, the fund can access the benefit of the increase. However, suppose the trustees consider interest rate increases are slowing or showing signs of dropping. In that case, it may be better for the fund to invest in medium to long term investments such as bonds or fixed-term investments.
Fixed Term Investments
As the name suggests, fixed-term investments include term deposits with a bank or financial institution, government or company bonds or debentures. The fund may hold these investments for the term of the bond or deposit, may be cashed in early at a discount or traded on the open market.
The impact of an increase or decrease in interest rates may result in the market value of the investment rising or falling. For example, as interest rates rise, the market value of a bond may fall because investors are able to use the cash they have to acquire a bond with a higher interest rate that provides a greater yield.
Where company bonds are held, other factors may impact their market value. This could be due, in part, to the issuing company’s performance and its capacity to repay the bond when it matures. It is worthwhile to review the company’s performance in conjunction with the potential changes in interest rates when judging whether the investment is worthwhile for the time the fund is expected to hold the investment.
In a volatile interest rate environment, there are many factors to consider when investing in listed equities. The factors can include the industry sector they are involved in, whether they are a new company or have been around for a while, share price volatility and interest rate history.
Interest rate volatility may impact the share price in a number of ways. For example, in an environment where interest rates are increasing, the value of shares in companies with high gearing levels may fall as the increases in loan repayments may impact profits. Companies that sell goods and services related to consumer discretionary items may see a fall in share value as consumers tighten their purse strings to pay for essential items such as home loans, fuel, and food. However, an increase in interest rates may impact the share price of companies that sell lower price goods, which may replace consumer discretionary items.
Interest rate volatility may have an impact on the price of a property as borrowers may be restricted in the amount they can borrow. Also, the price of new homes may be impacted by the increase in the price of building materials that companies with high levels of borrowing may manufacture.
What makes a good investment for an SMSF depends on each fund’s objectives. For example, a fund with relatively young members may be seeking investments with high capital growth and a lower amount of income being paid as interest, rent or dividends. In contrast, an SMSF consisting of retired or older members may be considering investments with higher income yields and lower capital growth to help with cash flow as benefits are drawn down.
A review and adjustment of the fund’s investment strategy may be required where markets move over time, or a member leaves the fund. However, this is a long-term objective and would be expected to occur at less regular intervals than rebalancing the fund’s portfolio. Any reallocation should aim to align the fund’s investments within its investment strategy and assets allocation ranges.
Rebalancing a portfolio that includes a sizable or ‘lumpy’ investment that has increased significantly may prove difficult to sell. Examples include real estate, shares in private companies or unit trusts and specialised investments such as artwork and collectables.
It may be left to the fund’s auditor to determine if the fund’s investment strategy and allocation are out of alignment. Failing to meet the investment strategy requirements and put that strategy into action is a compliance issue for the fund. It can be reported to the ATO by the fund’s auditor in an Audit Contravention Report (ACR).
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