Income Series 2019
Martin Ryan

Twenty years ago, increasing the income from your portfolio was straightforward: switch from shares to any other asset class, as dividend yields were lower than interest rates or income distributions from property trusts. Today, it’s not that easy.

To beat the grossed-up dividend yield on Australian shares today, you can skew the portfolio to high dividend stocks and increase your income, although there will be consequences for capital growth. Alternatively, you could hone your credit skills, or appoint an appropriate investment manager, to invest in debt securities.

This common challenge for investors is the focus of the Livewire 2019 Income Series. So, to provide a roadmap, in this special report I provide an overview of each of the asset classes listed below, as well as some of the pros and cons of each.

  • Equities – Australia
  • Equities – International
  • Australian Government Bonds (AGBs)
  • Corporate Bonds
  • Unlisted Real Assets
  • Residential Mortgage Backed Securities (RMBS)
  • Other Debt Assets
  • Hybrids
  • Alternatives


1: Equities - Australia

The total return from equities has three components: dividends + franking credits +/- capital movement. The current return for the first two elements is simple; the average dividend yield is 4.0% of which about 75% is franked, resulting in a pre-tax return of 5.20%.

Dividends have been extremely important in the total return on shares. Over the ten years to 31 March 2019, the return on shares of 10.0% p.a. has been made up of 4.7% p.a. from dividends and 5.3% p.a. from capital, a near 50/50 split. Including franking averaging 75%, the return equation is 4.7% cash dividends, 1.5% franking credits and 5.3% capital.

Historically, the return profile from asset classes is very different. Twenty years ago, the official cash rate was 4.75% and the dividend yield on shares was 3.20%. Now the cash rate is 1.50%. Hence investors are now forced to generate income away from capital stable term deposits and thus they have turned to shares in order to do so.

A characteristic of the equities sector is the range of individual investments and the associated investment products, from tailored managed funds and ETFs to structured products and derivatives. Many of these are targeting higher income returns.

Pros:
  • Established, regulated market
  • Liquidity high for 90%+ of stocks by market cap.
  • High level of research
  • Products available to suit your investment strategies
  • Transaction costs very low on base products
  • High income from dividends, with franking bonus
Cons:
  • High volatility vis a vis other asset classes
  • Significant variation in returns between stocks
  • Correlation of low prices with difficult economic periods
  • Dividends can vary
  • Highest risk on the credit spectrum

2: Equities - International

International shares have, in the first instance, two components of return; dividends and capital growth. There will be no franking credits, as Australian company tax has not been paid, but there may be some other type of tax credit. Currently, the dividend yield on the proxy for the FTSE Global All Cap Index is about 2.3% and the total return over the last ten years has been 11.3% (in $US).

The major point of difference from Australian shares is the expanded range of alternatives. Firstly, there are regional differences and then country differences. Some countries have industries which Australia does not have such as aeronautics, while others have specific types of companies for which there are no local equivalents, such as Google or Microsoft.

The second instance of return is currency. When investing internationally, you need to choose your currency strategy. Hedged, your investment returns are in $AUD. Unhedged, your investment returns are in another currency, $US more often than not.

Pros
  • A greater range of investments
  • Access to big winners
  • A range of investment products
  • Low cost alternatives, including direct shares
  • Low cost access to currency exposure
Cons
  • Lower dividend yields, no franking credits
  • Detailed knowledge of each countries’ political, economic and other risks is required.

3: Australian Government Bonds (AGBs)

With a AAA-credit rating, AGBs are one of the safest investments available anywhere. Half-yearly interest payments and the repayment of capital on maturity is guaranteed by the Commonwealth of Australia.

Institutional investors purchase these securities from a group of 18 AOFM-authorised banks. Further trading typically occurs in the “over the counter” (OTC) market via screen trading. Turnover of billions of dollars per day is common.

Retail investors can invest via the ASX in both fixed-coupon and inflation-indexed Exchange

Traded Bonds, with a minimum investment of 1 unit, or approximately $100. There are currently 25 fixed-coupon and 9 inflation-indexed alternatives (see here).

Whilst credit risk is minimal, investors have duration risk; that is, the longer the term of the fixed-coupon bond, the higher the capital price sensitivity to rises and falls in interest rates.

The current return (i.e. the net redemption yield) on a 3-year bond and a 10 year bond is about 1.30% and 1.70% respectively. If you sold each bond in one year’s time and interest rates were 0.5% lower, your return for that year would be 2.10% for the 3 year bond and 5.60% for the 10 year bond.

Conversely, if interest rates rise 0.5% in the year, returns would be 0.52% and -2.20% respectively. Of course, if they are held to maturity, the yield at purchase would be achieved.

The historical return on a portfolio of AGBs as reflected in the Bloomberg AusBond Treasury All Maturities Index has been 8.11% , 4.23% p.a. and 4.97% p.a. for periods of 1, 3 and 10 years to 31 March 2019.

You will not increase your income by investing in AGBs and the medium term total returns of 4% plus don’t match the income on Australian shares. You invest in this asset class for its diversification effect; returns are frequently the opposite of shares.

Pros

  • Low credit risk
  • Known half-yearly interest payments
  • Known final capital amount
  • Easy to buy and sell through the ASX
  • Price transparency, with liquid institutional pricing reflected in retail market
  • Diversification: returns frequently the opposite of shares.

Cons

  • Capital price will fluctuate between the issue date and the maturity date.

4: Corporate Bonds

Fixed-rate corporate bonds share the same duration risk as AGBs. Interest payments and principal are all fixed in the same way as AGBs and hence they share all the same characteristics.

Floating-rate corporate bonds pay interest at half-yearly or quarterly basis, calculated on a fixed margin above a base rate, typically 3 month or 6 month BBSW. BBSW is a benchmark rate and it can be thought of as a daily average of bank bill rates from actual transactions. However, the higher return they provide comes with various forms of credit risk.

These risks are:

General market moves in credit margins

The company-specific credit margin: if the issuer’s financial situation deteriorate, the credit margin will increase.

The security specific credit margin: subordinated debt margins can vary versus senior debt.

Institutional investors also trade these bonds in an OTC market. Some dealer groups will break down these parcel sizes so that smaller investors can participate.

There are some corporate bonds listed on ASX and traded in the normal manner. There are currently four ASX-listed fixed-rate corporate bonds and around a dozen listed floating-rate corporate bonds.

Returns on corporate bonds are determined primarily by the credit risk of the issuer and the nature of the security. A secondary influence is the term of the security. The longer the term, the higher the credit margin. This applies to both fixed-rate bonds and floating-rate bonds. The sensitivity of a bond’s price to a change in the credit margin is known as “credit duration”.

An example of a corporate bond (or note in this case; the two terms are often used interchangeably), is provided by NAB Subordinated Notes 2 (ASX code: NABPE). These notes are floating rate bonds which mature in September 2028 (but callable by NAB in September 2023). They pay quarterly interest at BBSW + 2.20% on a $100 face value. With BBSW currently 1.40%, the current income return from this Corporate Bond is 3.60%.

Pros

  • Higher returns than government debt
  • Liquid institutional market

Cons

  • Greater risk of insolvency than government bonds
  • Low liquidity on small issues

5: Unlisted Real Assets

This sector is typically property and infrastructure investments which are not listed on ASX.

Unlisted Property Funds

Unlisted real assets comprise investments in physical assets such as property and infrastructure, which are not listed on ASX. Investments of this type are often made in conjunction with other investors through two types of structure.

The major structures available include:

Syndicates, where multiple investors each own a percentage of a specific asset closed-end funds, where the original investors subscribe a fixed amount and the offer is closed. In addition, a syndicate or closed-end fund could have a projected term of, say 7 to 10 years, during which it is intended that the asset will be sold.

Open-ended funds, where investors exit and enter and assets are purchased and sold. The funds are typically structured as unit trusts.

Property projects account for the largest proportion of this sector by far and offerings are diverse in terms of objectives, management, time frame and risk/return. An example of this type would be an investment in a property development whereby broad acres are subdivided and sold as residential lots. These projects typically have a time frame of three years with forecast returns to the investor of 20% plus.

Major ASX-listed investment managers often operate mature unlisted property funds which offer investors the ability to purchase or redeem units in the funds. Current income yields are around 5% to 7% and capital gains and losses are continuously reflected in managers’ pricing of that fund’s units.

Pros
  • Regular income distributions
  • Regular property revaluations, providing transparency
  • Lower volatility than ASX-listed REITS and shares
  • Single purpose or diversified
  • Sector choice e.g. industrial, retail...
Cons
  • Small funds have no or limited liquidity
  • Some investments have high gearing

Infrastructure

These assets include airports, ports, roads, gas and electricity transmission which are too large for retail investors to access other than by a limited number of managed funds.

Unlisted infrastructure funds have similar pros and cons to unlisted property

6: Residential Mortgage Backed Securities (RMBS)

RMBS are a type of structured product backed by a pool of residential mortgages. The originator, typically a bank or other financial institution, sets up a special purpose trust and sells multiple mortgage loans to this trust. The trust is divided into tranches or classes which each have various risk/return characteristics. It then issues securities to institutional investors from the various tranches.

The total value of any series of RMBS typically ranges from around $100 million to several billion dollars. The total market value of all Australian RMBS is currently around $130 billion.

The various tranches of an RMBS issue obtain different credit ratings, ranging from AAA rated to unrated. The return increases with the risk.

As a guide to the current yields available, Latrobe Financial issued $750 million of RMBS via ten tranches at end of April. The first four tranches with the highest credit ratings were issued with the following interest rates:

Class A1S-S 1 month BBSW + 0.85%
Class A1S-L 1 month BBSW + 1.42%

Class A2-S 1 month BBSW + 1.85%

Class A2-L 1 month BBSW + 2.20%

RMBS are floating-rate securities. Their risks are trust specific credit risk (a weighting to a specific property market), credit duration risk and market credit spread risk.

Pros
  • An established market structure, with the RBA a market participant in the repurchase (“repo”) market
  • Higher returns
  • Frequent primary issuance and a liquid secondary market provide price transparency
  • Diversification within the structure via multiple borrowers
  • Diversification within a portfolio of type of credit risk
Cons
  • A very specific credit: housing prices and borrowers capacity to repay
  • Not available to retail investors
  • No “RMBS-only” managed fund (to our knowledge)

As a guide to historical returns, senior Australian RMBS have been issued at an average of approximately 1.00% above BBSW since 2009.

7: Other Debt Assets

For centuries there have been personal loans in various forms. The structured markets available today are primarily mortgages and peer-to-peer lending.

Mortgage investments are available as: 

Direct one-on-one loans, where the investor lends directly to a borrower secured by first or second mortgage. These loans can be for the typical 3 to 5 years with a low loan-to-valuation ratio (LVR) and yield around 5%. As the LVR increases, so does the return with short-term bridging achieving 20% plus returns.

Fund managers have a long history in this market and offer funds with a range of risk characteristics; income returns can be 7% plus.

Peer-to-peer investments are relatively new as a structured market, growing rapidly to replace some bank lending. Managers can act as agents to a direct transaction, fund managers and security issuers. Returns increase with risk and can exceed 7%.

Pros

  • Mortgage funds have an established structure
  • Returns rise to reflect higher risk
  • Some funds provide liquidity
  • Peer-to-peer lending’s relatively young track record is good
Cons
  • Direct lending and some securities have no liquidity
  • Peer-to-peer lending has restricted liquidity

8: Hybrids

Hybrid instruments combine features of debt and equity that can make them attractive instruments in which to invest. For many years, convertible notes offered the upside of a share with the downside protection of a bond. However, in the last few decades, they have progressively taken on more aspects of debt securities.

Hybrids can include convertible notes, preference shares, reset preference shares, step-up preference shares, converting preference shares, capital notes and others. They are typically designed to pay interest or distributions at a fixed or floating rate at regular intervals of either 3 months or 6 months until a maturity date some years in the future (currently, most are floating rate). In this manner, hybrids are very much like bonds in that payments are predictable in advance. These income payments may be franked (carrying imputation credits). At the maturity date, the principal is repaid.

However, the difference between bonds and hybrids is the discretionary nature of the payments. Strictly speaking, directors may decide not to make a distribution, although such an omission would negatively affect the issuer’s reputation.

There are no (or extremely small) capital gains to be made on hybrids held to maturity, so returns are limited to distributions. Nowadays, almost all distributions are referenced to the bank bill swap rate (BBSW) plus a margin. The average margin, including franking credits, has been around 3.50% since 2010. With a cash rate of 1.50% and BBSW at 1.60%, investors could expect to average 5.10% (grossed up) per annum or 3.60% fully franked. If the cash rate were to increase, returns would also increase. Current yields on a daily basis can be found here.

In normal times, hybrids prices are unlikely to move more than 5% above or below face value. However, hybrids may expose investors to "equity-like risks" at "bond-like" returns in times of crisis. Prices of hybrids fell heavily in the GFC, in some case by nearly 50%. However, they recovered as confidence returned to financial markets. Distributions continued to be paid and when each of those hybrids matured some time later, investors received the full face value. In the end, if the issuer was sound, so was the security.

Pros

  • Higher returns than senior debt
  • Typically coupons are floating rate; capital risk is reduced
  • Returns are less volatile than shares
  • Issuers are often highly rated by credit agencies
  • Easily available to retail investors on ASX
  • Provides diversification

Cons

  • Returns are more volatile than bonds
  • Rank lower in the corporate structure than bonds
  • Distributions are at the discretion of directors
  • Lose their bond-like characteristics in financial emergencies
  • Expected to absorb losses in order to protect bond holders

9: Alternatives

Alternatives consist of everything that is not included in other asset classes and will therefore have return characteristics with low/no correlation to other asset classes.

This includes:

Commodities: Prices tend to reflect specific circumstances such as weather (orange juice, water rights) or negative sentiment (gold).

Hedge funds: These funds seek to generate their returns irrespective of market direction.

Structured products: These products are financially engineered to achieve specific outcomes and can trade off risk/return, income/capital, capital guaranteed/total return and more.

It is difficult for retail investors to access the components of this asset class except through managed funds.

Pros
  • Returns are uncorrelated with other asset classes
Cons
  • Management fees can be high
  • Large variations in returns
  • No universal benchmark of returns
  • Some funds strategies alter rapidly such that you don’t know your investments
  • Some strategies employ high leverage through futures

About Yield Report

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