Harold does have to take on a small increase in risk with hybrids but really, the banks going bust?

Harold does have to take on a small increase in risk with hybrids but really, the banks going bust? Photo: Nic Walker

In our last article I introduced you to Harold, a friend of mine who writes in the Marcus Today retirement newsletter. He ''lives the dream'' of retirement and last week started telling us about his retirement portfolio, how he sees asset allocation for the income-hungry retiree. His first decision, you might remember, was to bin the concept of diversification, which seemed more suited to financial advisers not wanting to get sued than to retirees wanting safe income.

Of particular concern is how much money to put in the banks. If you include the compounding of dividends the banks are more than 40 per cent higher now than the highest high in 2007. That compares with a market still 24 per cent below the high.

Yet Harold, and doubtless many other retirees, out of respect for diversification and the sector's 26 per cent market weighting, didn't hold enough banks. The diversification mantra held him back. But it was wrong and as the banks continue to be a highly protected oligopoly, Harold's first decision, take it or leave it, is to hold more banks in his portfolio than ''normal''.

Decision one, a healthy dose of banks.

Decision two is again income oriented: to hold a decent slug of hybrids. Hybrids are just you lending companies money rather than lending the government money and them paying you a fixed or floating interest rate which is franked or not franked and which is repaid under certain conditions on a pre-ordained timetable.

The main price drivers are the credit rating of the issuing company and the interest rate they are prepared to pay, but if you hold to maturity you can pretty much ignore the price in between because you'll get a dollar for a dollar at the end.

While some fixed-interest professionals tell us compared with more traditional bonds the recent flood of hybrids have been generally riskier and overpriced, the most recent hybrid issues have been snapped up by the SMSF industry, who don't care about the price. They just feel the yield.

The reason they've ''overpaid'' is that the cashed up SMSF collective is currently populated by equity investors that are used to a bit more risk, and quite honestly don't give a toss about the subtleties when safe income investments are in short supply.

Last week, for instance, the NAB announced a $750 million hybrid issue but doubled it to $1.5 billion to meet demand.

The new breed of hybrids are walking off the shelf with their fully franked yields because they have cleverly targeted the safe income SMSF appetite rather than the bond market intelligentsia.

This is not advice, but Harold is holding 40 per cent of his portfolio in hybrids.

This, he says, reflects a response to the very unstable conditions we all experienced during the GFC as well as the last couple of years the market spent stressing about the debt issues in Europe and the US. It also reflects concerns about the slowdown in China and the impact that would have on Australian equities prices.

Why would you sell?

His hybrids when he bought them were yielding 10 per cent but are now yielding between 7 and 8 per cent. On his purchase price it's still 10 per cent, so why would you sell? As his hybrids mature he intends to replace them with more hybrids or new hybrids that may not yield 10 per cent any more but still yield more than term deposits.

When it came to hybrid selection he has played it safe; all his hybrids are in major banks and have a fixed maturity date, so he knows that despite daily fluctuations in price, he will get his money back unless they go bust. On the way he should get almost double the current term deposit rate.

Of course he does have to take on a small increase in risk, but really, the banks going bust? Again, if that happens we'll have more to worry about than our equity portfolios because the country would have gone to hell.

That's banks and hybrids. Harold also keeps a modest amount in cash to pay his pension and has worked with his bank to get the best interest rate he can through a combination of accounts. The interest on the account in which he holds most of his cash is close to the better rates for term deposits.

His cash target is roughly 10 per cent although it has been running much higher after some profit-taking, leaving him searching for investments to take up the remaining 30 per cent of his portfolio.

So Harold's retirement portfolio has 70 per cent in stocks and hybrids, which are as close as he can get to cash. That leaves 30 per cent of his portfolio available to take advantage of opportunities that occur in the broader stock market. He also keeps some money aside for trades. When you get a bit ahead of the eight ball, taking the odd trade, doing the odd thing in the short term gets you up in the morning.

It is what Harold calls ''fun investing'', and with a bit of discipline and a lot of vigilance it is generally rewarding.

Well that's Harold and his retirement portfolio. He's not you, remember, but he and I hope you get some value from it.

Marcus Padley is a stockbroker and the author of stock market newsletter Marcus Today. For a free trial go to marcustoday.com.au.