In the current environment it’s time for investors – and their advisers – to look beyond the benchmark.
With interest rates hovering around historical lows globally, investor appetite for alternative income sources has markedly increased. In the current environment uncertainty is writ large; challenges come at investors from all angles – global and domestic, as well as longer term structural challenges.
In this article, Damien McIntyre, CEO of GSFM Pty Ltd, discusses where investors can find yield without exposing their portfolios to too much risk.
Although the US Federal Reserve (the Fed) last year raised rates, interest rates in Australia are at an all-time low and, according to government rhetoric and the Reserve Bank of Australia (RBA), may head lower still following the catastrophic bushfires that continue to destroy parts of the country. Low interest rates create a problem for investors, advisers and investment managers – how do we create sufficient returns and adequate income to meet investors’ needs?
In many cases, investors are going further out on the risk curve, taking on more risk than they usually would, to generate a nominal return to meet their income needs. This is particularly pertinent to retirees living on a fixed income.
History tells us that the further investors push out along the risk curve, it’s all fine until it isn’t. A trigger event – such as 2007-2008’s global financial crisis (GFC) – can bring markets to their knees. Those investors who have a greater exposure to risk are more likely to have a greater exposure to capital loss. With markets in Australia and the US having this reached record territory, there’s a lot of uncertainty around how much further equity markets can go.
Despite this uncertainty, coupled with the $980 million cash on deposit at the end of November 2019[1], investors are hunting for alternative sources of income. Are they looking in the right places?
Bonds aren’t necessarily the panacea
There was a time when an allocation to bonds could be relied on to provide regular income to investors. However, since central banks around the world adopted quantitative easing programs to counter the GFC, bonds haven’t played this role in the same way.
Paltry yields from fixed-income investments have become the norm, making income generation an arduous task. Sovereign bond yields are negative for short and intermediate-term maturities in much of the developed world, with the US, UK and Australia being notable exceptions. Real yields are negative for an even broader set of maturities and countries.
Domestically, the yield on the Australian 10-year government bond fell below 1% for the first time in August 2019. Since then, there’s been little change – at 29 January 2020, the Australian 10-year government bond yield closed at 0.95% and on five year bonds, at just 0.67%[2]. Although the price of those bonds would have risen, from an income perspective, an investor is being paid less than the average six month term deposit rate in return for locking their money up for five or ten years.
There are many reasons bond yields could rise. Central banks in North America and Europe would eventually like to normalise monetary policy and step away from the quantitative easing that was designed to hold rates down, but that appears like a distant hope in the current environment. In the US, wider budget deficits and an expanding supply of bonds from both the public and private sectors could eventually provide upward pressure.
Over the long haul, however, interest rates are a reflection of economic growth and inflation. Economic growth in developed countries is challenged by an ageing population and stubbornly low productivity growth (at least as it is traditionally measured). So while the global economy is growing, it is showing signs of a slowdown and its growth rate will remain hostage to these powerful secular forces.
So, can investors get income from bonds in this market? The short answer is yes – but less probable from a traditional bond fund or passive investment tied to a fixed income index. Instead, an absolute return approach can be a better option in such an environment.
Absolute return funds are benchmark agnostic, generally managed to a cash benchmark. The manager won’t passively adopt the largest exposure to the biggest debtor or adopt a long duration because that’s where the index is. Instead, the manager has the ability to ‘cherry pick’ the bond issues (and issuers) with lower duration (i.e. less interest rate risk), a better yield and which are best placed to deliver on each fund’s objective.
The power of dividends
Australian investors are well versed in receiving dividends – after all, last year’s federal election was, in part, lost and won on the issue of franked dividends. Typically overweight domestic equities, many local investors are unaware of the dividend potential of investing globally. Dividends are important for two reasons – they provide income and stability.
The saying “profits are a matter of opinion, but dividends are a matter of fact” encapsulate the reason that dividend paying companies tend to hold up well during uncertain times but may lag when PE growth dominates.
A high number of uncertainties exist in the world’s geo-political environment – the emerging coronavirus, Trump’s trade war with China (is it really over?) and his impeachment proceedings, the ramifications of the UK-EU divorce, the impact of climate change – each has the potential to destabilise markets. It’s times like these that dividend paying companies come to the fore. Why? Profits are calculations based on a range of real and estimated data and have been known to be overstated; dividends are tangible, paid from corporate earnings.
As such, dividend paying stocks can provide investors with tangible returns on a regular basis, irrespective of market conditions. Over the long term, companies with stable or growing dividends perform better and display less risk than those cutting or not paying dividends (figure one). Although some investors might be fearful of dividends being affected by market volatility, history tells us that dividends are, in fact, remarkably resilient in volatile markets.
The potential for dividend-paying stocks to help meet income goals has gone underappreciated. Yet these equities hold up surprisingly well in terms of yield, return and risk among these options.
Income from high-dividend stocks is superior to investment-grade bonds. Moreover, that income has been remarkable in its relative stability in an environment of collapsing bond yields. To illustrate this, figure two shows the yield history of Epoch’s global dividend oriented portfolio as a proxy for what has been achievable.
Active management makes sense for dividend-oriented portfolios
Dividend-paying equities is one area where manager universe averages have been able to improve upon the return profile of their benchmarks and often with substantially lower volatility.
How can this be achieved? In theory, dividend-paying stocks should have a leg up on the broader market in terms of stability because once a dividend is paid, regardless of how a stock’s price fluctuates from there, you are starting out with the cushion of a positive return. Furthermore, requiring a meaningful dividend excludes many growth-oriented companies that are younger, less well established and typically have more volatile price swings.
Companies with the highest dividend yield in the market often end up cutting that dividend. For example, financials had relatively high dividend yields leading up to the GFC. But of course, those dividends were unsustainable in the aftermath of the crisis, and most banks were forced to slash or even eliminate their dividends. Similarly, many energy stocks appeared to sport very high dividend yields in 2015, because the sharp drop in the price of oil had driven their stock prices lower. But they, too, were forced to eventually cut their dividends, because the low price of oil meant they did not have the operating cash flow to sustain the previous level of those dividends.
This is where active management can help. Through fundamental research on individual companies and the durability of their cash flows, active managers can focus on those where they believe dividends are sustainable and can grow. Equally important is determining whether a company’s management team has a capital allocation policy that is disciplined, transparent and shareholder friendly. A long track record of regular, growing dividends speaks volumes about a company’s stability and the priorities and shareholder orientation of its management.
Companies that pay and grow dividends tend to be mature and well established, with the ability to withstand downturns and steadily grow their business throughout business cycles. While different managers use different approaches, in aggregate they have been able to provide a substantial yield with equity-like returns, but with much less volatility than the broader equity market.
A shareholder yield strategy
Shareholder yield is a term investors are hearing more frequently. Cash dividends are the most obvious means of returning cash to shareholders. However, buying back shares and paying down debt are also legitimate ways to return cash, as both provide shareholders with a larger claim on future cash flows. Collectively, dividends, share buybacks and debt pay-downs are known as ‘shareholder yield’.
Dividend-paying companies must be actively vetted for growing free cash flow (to sustain and potentially grow dividends) and for management teams that prioritise shareholder distributions – including share buybacks and debt pay-downs – as part of a disciplined capital allocation policy.
Therefore, it’s important to invest with a manager that focuses on dividend sustainability, and whether those dividends can be increased over time. A share portfolio comprised of companies paying a sustainable and growing dividend will be better positioned to provide a consistent level of income and ride out challenges in the years ahead. A portfolio of stocks with these characteristics can go a long way in providing income to investors.
In the current environment it’s time for investors – and their advisers – to look beyond the benchmark. While a benchmark might be a satisfactory compass, it doesn’t always provide a true guide forward. In the search for income, taking on more risk isn’t necessary. Investments that eschew mimicking a benchmark index in favour of delivering positive outcomes for clients should be your focus.
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[1] Monthly Authorised Deposit-taking Institution Statistics, APRA, November 2019
[2] https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
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