Stalling global economies, collapsing share prices and looming war have forced investors to switch out of shares into defensive-style, income-paying investments.

But with interest rates at a 30-year low many investors, particularly those who need the investment income to live off, have been steadily moving up the risk ladder.

While defensive investments such as listed property trusts, mortgage trusts and fixed-interest investments pay steady income and are known for their preservation of capital, some are at, or near, the top of their investment cycles and could spell capital losses down the track.

Listed property trusts

The sector has grown almost 300 per cent, from $13.5 billion at the beginning of 1997 to about $50 billion. Listed property is one of those investments that forms the backbone of conservative portfolios and is especially loved, for good reason, by retirees.

First, the large, well-diversified, listed property trusts pay a fairly consistent 7 to 8 per cent a year, earned on the long-term leases of the underlying properties. Then there is the capital appreciation of between 3 and 4 per cent a year over the long term. But investors new to the sector may not realise that their capital can go backwards in the short term. Being listed, their share prices move in line with investors' expectations of how the property sector will perform and whether better returns can be found in other stockmarket sectors.

In 1999, the sector lost 5 per cent. As a steady 7 per cent is returned to investors each year, this means that investors' capital went backwards by 12 per cent. "Because there has been a general shift to defensive investments over the past 12 to 24 months a lot of the listed property trusts are starting to look fully priced," says Sean Webster, investments research manager at financial planners Berkley Group.

He says just as defensive investments are starting to look fully priced, growth investments, such as industrial shares, are looking cheap. "It is easy to see a situation where the investment environment could change quickly," says Webster.

He says with low interest rates, which are good for stockmarkets, any pick-up in global economic growth could see the stockmarket come back quickly, with investors rotating out of listed property and into growth stocks.

Property funds

Like the directly listed property trusts, property securities funds are bursting at the seams with conservative investors' money. "The lack of sufficient investment opportunities in the domestic market has driven the fund managers to look for alternative investments," says ING research manager Gavin Shepherd.

The managers have been inundated with money and cannot find enough listed property of sufficient quality to invest in, he says. "As a result, managers have lifted their holdings of direct property and property-oriented listed companies," says Shepherd. Some managers are also beginning to invest in international real estate investment trusts, he says. As a result, the funds may be riskier than many investors think.

Shepherd believes that listed property will continue to be an important part of a properly constructed, diversified portfolio, but that investors need to do their homework and check where the funds are investing.

Mortgage funds

Research house Assirt says that the net inflows into mortgage trusts was $1.9 billion for 2002, from $1.17 billion in 2001. When the bulls were running in 2000, mortgage funds recorded a net outflow of $387 million. They typically pay monthly income of between 1 and 2 per cent, after fees, above cash management trusts. Unlike property securities funds, there is no underlying stockmarket risk. The unit prices or capital value of the mortgage trust stays at $1 and pays out the income to investors each month.

Research produced last year by Lonsec Research showed that some mortgage funds are holding almost half of their assets in cash, causing their returns to be lower.

The test of the managers with too much cash on their hands is to resist the temptation to lend to borrowers with a higher chance of default.

The danger increases if interest rates were to rise, because the bad risks could be expected to struggle with higher interest costs on their loans. Grant Kennaway, the head of managed funds research with Lonsec, says some mortgage funds have been investing into bonds of up to one year. This opens the funds' investors to interest rates risk. If interest rates rise the capital value of a bond falls.

In 2001 Westpac closed its mortgage and income fund and devalued its units after suffering losses attributed to a mortgage-based security in the US.

Capital guarantee

Estate Mortgage, an unlisted property trust, along with others, collapsed in 1990 after mortgage rates hit 17 per cent and the speculative property bubble of 1987-89 burst. Estate Mortgage's capital guarantee did not exist.

ASIC says that genuine capital guarantee investments either have lower returns because the investment is a low risk one, or the investor pays extra for the guarantee.

With "capital stable" managed funds there is no guarantee that capital will not be lost. It is simply a marketing label and means that the fund's underlying investments are interest-bearing investments, such as fixed interest or cash. In other words, the value of the units can go down if interest rates rise.

Structured investments

Bailey says the higher yields that they pay come at the cost of transferring risk to the investor. "Some investors think they are getting a yield of 10 per cent for not much more risk than cash," he says. The risk comes by way of stockmarket volatility and corporate bonds that are not always of investment grade. "They are no place for conservative investors to play," he warns. Bailey says these products often come from the stockbroking arms of investment banks.

He says investors must be careful not to get blinded by the science of the product. Despite the marketing pitch of some of the providers, they are not risk-free and not guaranteed.

Listed interest rate investments

They include listed debt securities, such as capital notes, convertible notes and preference shares. They also include the latest hot product on the market, known as hybrids, some of the best known being the St George Prymes and Coles Myer ReCaps. At the end of the fixed term, during which a fixed rate is paid, these types of product revert to shares in the company.

Income securities are different in that they pay a floating interest rate, which is a fixed margin, typically 1.5 to 2 per cent above the cash rate and can act as a hedge against rising rates. Unlike hybrids, such as resets, where at the end of the period the reset converts to shares, income securities are a perpetual investment, though being listed they can be sold at any time. Listed interest-rate securities tend to yield between 6 and 10 per cent - the higher credit rating of the issuer, the lower the yield. Investors need to understand that though they are sold as safe investments, they have their risks. For example, the woes of AMP's UK operations have flowed through to investors holding the company's reset preference shares. Two weeks ago the credit ratings agency Standard & Poor's downgraded AMP's credit rating to A- from A with a negative outlook, and the reset preference share was moved down to a rating of BBB, just one step away from junk-bond status.

During the past seven weeks, about 6 per cent has been wiped off the value of the AMP resets. That means that investors who bought the issue on debut in October last year for $100 would be holding resets worth $94. Income securities received bad press with NAB's issue trading at $6 below its issue price of $100. The trouble with listed interest-rate securities for retail investors is that they are difficult to price, which is why advice is essential.

Berkley Group's Sean Webster uses income securities and reset preference shares for some clients. He says income securities are useful as a hedge against rising interest rates and uses them in a portfolio to offset the falls experienced by fixed-interest investments when rates rise.

Investors need to be aware that the only free lunch in investing is diversification, says Bailey. If an investment is offering a higher return, he says the risks must be always higher. If you can't afford to risk your capital, there are safer alternatives. Financial planners recommend investors focus on cash and fixed-interest options. But if you have a mountain of debt on your mortgage and variable interest rates are about 6.5 per cent, or the equivalent of 13 per cent before tax, you may be better off parking your money in there and clearing the debt.

Andrew Willink, managing director of Cannex, says inflows into cash management accounts and term deposits run by the 12 leading banks jumped by about 25 per cent in 2002 as investors quit the stockmarket. But whatever you do, make sure you don't leave your cash in a transaction account where, if you are lucky, it will earn 0.2 per cent.

Cash is king

CPA Australia's manager of financial planning, Kath Bowler, says there are two reasons for this: "Often [investors] need to have a cash-type account when they are investing through a wrap account or a master fund and it is also because [planners] get commissions from them."

Margaret Callinan, research manager at Tandem Financial Services, says many CMTs come with cheque books and credit cards but their returns are between 3 and 4.65 per cent. CMTs should not be confused with the cash management accounts offered by major banks. These accounts have tiered rates, which means the top rates of between 3 and 4.5 per cent only kick in when you have a balance of $50,000 or $100,000 plus.

While term deposits offer certainty of return, they can be inflexible. If you want to pay no fees and get the maximum return, the best place to park your cash is still the internet-style savings accounts.

As the table shows, the highest rate of 5 per cent is offered by Easy Street Financial Services, a subsidiary of Community First Credit Union.

However, be warned, if the balance falls below $998 no interest is payable. ING Direct, AMP and Dragon Direct offer their top rates on balances of $1.

In most cases, you will also need to run a normal bank transaction account to access your money.

Fixed interest

If you choose the direct option make sure you follow Bruce Noble's example and spread your money across maturity dates, issuers and types of investments (see case study).

At the lowest end of the risk spectrum are government bonds issued by the Federal Government. Because they are more secure they have a lower interest rate than other fixed-interest options.

Semi-government bonds pay a slightly higher rate.

These are issued by a government body other than the Federal Government, such as the various state governments, at about 4.7 to 4.9 per cent (see table previous page).

Tony Lewis, managing director of Lewis Securities, says the beauty of bonds is their safety and regular income stream. Higher on the risk/return scale are corporate bonds and debentures. Debentures are a method by which companies can raise capital and the interest may be paid annually, half yearly, quarterly or monthly, or it may be compounding.

These can be issued by finance companies such as Esanda and CBFC.

However, Watkins says there is not a great deal of value in the well-rated debenture market, with interest rates ranging from 4.75 to 4.95 per cent.

Other debentures are available, offering rates of between 7.5 and 11.5 per cent, but it is important to do your research on the underlying company. "Always be suspicious if the rates are too attractive. If they are in the double digits there's a reason," says Watkins.

One way of assessing a debenture investment is to look at the credit rating that the issuing company has from Standard & Poor's (S&P).

However, recognise that not all of the issuing companies are rated and it is not an absolute guarantee of the investment's safety.

Also look at the lending criteria of the finance company issuing the debenture. Ideally, they would be lending on first mortgages and with a maximum loan-to-value ratio of 80 per cent. Lewis says often the reason companies are able to offer higher returns on debenture issues is because they are lending money to property developers. "If the property developer goes bust who's going to repay the debenture?" he says.

Another consideration is the liquidity of the various options. Government bonds can always be sold very easily, says Watkins.

However, it is possible to make a loss on a bond investment if you sell before maturity and interest rates have risen substantially since you bought the bond. Debentures are far less liquid. Investing in these assets can require larger lumps of money to make it worthwhile although it is possible to invest in bonds with a minimum of $1000.

Anyone who has capital protection as their first priority should do some thorough research before placing their money into these investments.

Faith in protection

Although his self-managed super fund contains a spread of equity and property assets, he has also put some of his portfolio into direct fixed-interest investments to protect himself from the risks of investing in equity assets in volatile markets and to create income.

"I have invested in a couple of different government bonds yielding between 6 and 6.25 per cent, which I anticipate holding for a number of years so that I receive a regular income that's secure," he says.

The 58-year-old Bellevue Hill resident is aiming to have 15 per cent of his portfolio in fixed interest. However, he says it is slightly below that now because he cannot find the rates that he is hoping for longer term. While he is waiting for equity markets to stabilise, the former financial controller of Coca-Cola Amatil is keeping some funds at the ready.

He has put some money in three- and six-month term deposits returning about 4.75 per cent. Although he admits returns on his short-term investments could be higher, he says: "I'm still getting a greater rate than if I had all my available cash at call."

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