“We have seen the share prices of larger defensive businesses like Telstra, CSL and Ramsay Healthcare rise strongly over the past twelve months.  We have also witnessed the slightly bizarre situation of the Big 4 Australian banks outperforming the wider Australian equity market,”  said Andy Gracey, Portfolio Manager, Australian Ethical.

“The primary reason large banks have outperformed is the singular focus of investors on the yield, with the major banks currently offering a fully franked 6.7% yield on a market cap weighted basis.  We see this share-price out-performance as paradoxical given banks are highly leveraged to the domestic economy, with changes to consumer and business behaviour capable of wreaking havoc on bank profitability. 

“The unprecedented decline in yields on Australian commonwealth government securities together with the cuts in base interest rates by the RBA means sustainable yield is becoming harder to find.  This is highlighted by a risk free investment in 10-year Australian government bonds today offering a paltry 2.8% yield per annum.

“The cash rate which is perhaps more relevant to local investors is predicted to be just 2.9% by December 2012 if the bank bill futures are to be believed.  This may translate to financial institutions offering investors around 4.1% for cash and short term money by the end of 2012 (today the average spread for deposits is 1.2% on top of the 90 bank bill rate).

“Our funds have sought exposure to investments which offer sustainable yield.   These include utilities such as APA, Envestra and Duet. The yields on offer are reasonably attractive with stable contracted or regulated cash flows. The key risks are changes to regulations governing their return on capital and the relatively high level of gearing (albeit the regulator views a 60% gearing metric as appropriate given the stability of the cash flows). The likes of Duet also have an out-of-vogue management contract which means investors pay AMP/Macquarie Bank potentially large performance fees.

“We have increased our holdings of real-estate investment trusts “REITS” such as Stockland, Mirvac, Investa Office Fund and the Commonwealth Property Office Fund. This sector carried too much debt coming into the GFC but post raising new equity capital they now have what appear to be conservative levels of debt at between 20 to 30% of total assets.  The sector still trades at a discount to net tangible assets. Like Duet, Commonwealth Property Office Fund also comes with a management contract that includes a performance fee.

“We also continue to hold the Transpacific hybrids securities which are preference shares trading at 85 cents in the dollar. The health of these hybrid securities rests with the health of the ordinary Transpacific Industries share which today is solely focused on reducing its debt and attaining investment grade status.  We take some comfort that while interest coverage and Debt/EBITDA is not yet investment grade it is heading in the right direction and the debt metrics are not inconsistent with global integrated waste companies,” said Gracey.

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