There is nothing wrong with term deposits. Government guaranteed investments (up to $250,000 per investor per financial institution) paying a regular income. And you can still earn more than 2% (for example, ING Direct is paying 2.3% pa for an 11 month term deposit, or RaboDirect 2.15% pa for 5 years).

If you are an income investor and not happy about the interest rate on term deposits, then you will need to go up the risk curve. Lower rates are here to stay, so the only way to increase your return is to take on more risk.

Risk means that you could lose some or all of your capital. If capital preservation is your main goal, then taking on more risk is the wrong strategy.

However, if you are prepared to “chance your arm”, you can increase the return by taking on riskier investments. Here are 5 riskier alternatives to term deposits. These are ordered by “riskiness” (my assessment, from least risky to most risky and excludes growth assets such as shares and property).

1. Secure fixed interest – investment grade bonds and funds
2. Risky fixed interest – bank hybrids
3. Diversified global infrastructure
4. Risky fixed interest – credit funds
5. Risky fixed interest – alternatives

1. Secure fixed interest – investment grade bonds and funds

The biggest borrower in Australia is the Federal Government who issues Treasury Bonds. After that you have the States, our major banks, and large corporations.

Yields (think interest rates) on treasury bonds are pretty unattractive – currently around 1.45% for 10 years. State Governments pay a little bit more, banks more again and corporations – it depends on their creditworthiness. Suffice to say, there isn’t much on offer of investment grade quality yielding over 3% pa.

Of course, you can buy individual bonds through various fixed interest brokers (these often won’t be investment grade or “secure”) but it is hard (but not impossible) to get a diversified portfolio.

A relatively easy option is to consider a couple of the fixed interest exchange traded funds. I like the ones of shorter duration and taking on a little more credit risk – so iShares Core Composite Bond ETF (ASX:IAF) or Vanguard’s Australian Fixed Interest Index Fund (ASX:VAF) would be my pick.

Be very wary about some of the terminology when it comes to fixed interest. If you are a holder to maturity, the only metric that counts when comparing bonds of the same term is ‘yield to maturity’. Terms such as ‘running yield’ are mathematically meaningless. They were invented by bond salesmen in the days before calculators – and had its origins in the USA where even to this day, calculations are based on a “year” having 360 days (rather than 365 days). Remember, if you pay $105 for a bond, you only get back $100 when it matures – you need to factor in the $5 capital loss.

2. Risky fixed interest – bank hybrids

I categorise bank hybrid securities as “risky” fixed interest because if the bank gets into serious trouble, you will probably lose about 80% of your capital. Some people refer to hybrids as ‘equities’ because they form part of the bank’s capital, but unlike normal shares,  they have absolutely no upside. You will never get more than your $100 back.

They are complex instruments – so  if you don’t understand them or don’t want to understand them, don’t invest in them. ASIC’s MoneySmart website (www.moneysmart.gov.au) can help here.

Hybrids have become “super expensive” because every financial planner in the country is presently recommending them to his or her clients, so I am a little wary of recommending individual issues. One way to access the market and obtain a diversified portfolio is through Betashares Active Australian Hybrids Fund (ASX: HBRD). This is managed by Christopher Joye’s Coolabah Capital. The downside is the management fee of 0.55% pa.

If you do buy individual hybrid securities, try to build a diversified portfolio with multiple issuers. Here are some points to note:

• It is a classic “supply/demand” market. At the moment, it is all “demand”, so prices are rising, There will be new issues which when they hit, will push prices lower;
• You should assume (with bank hybrids) that the hybrid will be called (that is, redeemed by the issuer for $100) on the first available call date;
• If you are going to hold to maturity (the call date), look at the ‘trading margin” when comparing hybrid A to hybrid B. Running yield is pretty meaningless;
• You only get 70% of the coupon (they are already expressed as “grossed up” rates that include the benefit of franking); and
• Current yields (including franking) are around 4.0%.

3. Diversified infrastructure funds

Last week, Tony Featherstone outlined the case for global infrastructure (see https://switzersuperreport.com.au/5-top-infrastructure-funds/). He said: “Invest globally: Australia has only a handful of large listed infrastructure companies. Focus on funds that invest in listed rather than unlisted infrastructure and have higher liquidity. Choose unhedged currency exposure because the Australian dollar will edge lower this year.”

He nominated 5 funds with diversified portfolios to consider:

1. Maple-Brown Abbott Global Listed Infrastructure Fund (unhedged)
2. Magellan Infrastructure Fund (ASX: MICH)
3. Lazard Global Listed Infrastructure Fund
4. RARE Infrastructure Value Fund – unhedged
5. Vanguard Global Infrastructure Index ETF (ASX: VBLD)

These are long-term investments, which will be impacted if interest rates go up. Tony’s caution is worth repeating: “Most of all, have an investment time frame of at least seven years, preferably longer. Global infrastructure is a long-term portfolio asset, not one for speculators or those seeking double-digit returns every year.”

Also, if the fund publishes a NTA (net tangible asset value), check this first before investing to make sure that you aren’t paying “over the top”. Magellan (ASX: MICH) publishes an intraday real-time iNAV (indicative NAV) on its website.

4. Risky fixed interest – credit funds

Percy Allan wrote about these on 13 June (see https://switzersuperreport.com.au/what-income-funds-might-defy-a-stock-market-slump/). He nominated 4 listed funds:

• Qualitas Real Estate Income Fund – (ASX Code: QRI)
• MCP Master Income Trust – (ASX: MXT)
• Gryphon Capital Income Trust – (ASX: GCI)
• Neuberger Berman Global Corporate Income Trust – (ASX: NBI)

These are diversified funds investing in developer senior and mezzanine loans, corporate loans, residential mortgages and global high yield bonds respectively. Most pay monthly interest, targeting from 8% pa (in the case of Qualitas) to 5.25% pa for NBI. Personally, I like NBI because of its diversification (about 350 bonds from geographically and industry diverse issuers).

In the unlisted environment, you could include Latrobe Financial’s credit fund as well as others.

Points to consider:

• It is really important to understand what the credit fund is investing in, the duration of those investments, the level of diversification, and the underlying liquidity of those investments. Typically, corporate loans, mortgages and developer loans are not liquid;
• If the fund publishes a NTA, check the purchase price with the NTA – don’t pay too much of a premium for the investment.

5. Risky fixed interest – alternatives

Alternative investments include borrowers such as Investors Central, IPO Wealth and others. In some cases, you will need to be a “wholesale” or “sophisticated” investor to be eligible to invest. This requires an accountant’s certificate saying that you have net assets of at least $2.5m or an income over $250,000. Retail investor protections such as “cooling-off” periods do not apply to wholesale investors  – the Law assumes you understand what you are doing. .

And that’s the important point with this category of investment. It is higher risk because the “underlying assets” that are effectively securing your investment are higher risk. For example, Investors Central is in the business of providing finance (via a subsidiary) to people buying second-hand cars; IPO Wealth invests via a subsidiary in unlisted private companies in emerging sectors and emerging markets. A thorough reading of the Product Disclosure Statement or Information Memorandum is an absolute pre-requisite for investors.

Never invest in anything you don’t understand. And if you do choose to invest in higher risk investments, invest in moderation – generally, the higher the risk, the smaller the proportion of your assets that should be exposed to one single asset.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.