Investors searching for yield in this environment of falling interest rates can be tempted to head down a risky path which overlooks the basic rules of diversification.

The importance of an adviser’s role in assessing their client’s specific needs and crafting a diversified portfolio that can support sustainable spending is crucial.

Vanguard’s research paper ‘Desperately Seeking Yield’ highlights a number of examples that illustrate the dangers of pursuing yield in individual assets without considering the various risks.

The research shows that diversified income generated by Australian equities plays an important role in most portfolios particularly as equity investments also provide the opportunity for growth. However to offset the systematic risk which equities generate, including other asset classes such as fixed income to moderate the volatility can be beneficial – this is demonstrated by the table below showing the diverse profiles of various income generating asset classes.

Lower yields from traditional fixed income investments have prompted some investors to over-concentrate a portfolio on a small set of assets or select assets with promises of fixed income like outcomes, however these tactics have inherent risks.

One example is hybrid securities which are marketed with yields superior to common debt offerings, however, in times of market stress issuers have exercised the flexibility of non-uniform terms to vary or cease coupon payments entirely.
The major shortcoming of focusing exclusively on yield from one asset class is material as it undervalues the importance of diversification in portfolios. Such a strategy can also challenge a portfolio’s liquidity and the sustainability of the yield itself.

Focusing instead on a ‘total return’ approach, which encompasses both income and capital return components, can serve to maintain portfolio diversification and increase the longevity of the portfolio.

In the scenario where outgoings exceed income, drawing from capital appreciation of the portfolio rather than sacrificing diversification and over-weighting higher yielding sectors of the market can improve portfolio longevity.

Even in situations where yield is a high priority, portfolio construction should still adhere to fundamental asset allocation principles, investors would be better served not chasing the prevailing yield of the day, but seeking diversified income streams by focusing on total returns.

Whether investors are early in their investing life or drawing on a portfolio in retirement, the opportunity exists for advisers to offer value through assisting clients to understand the value of diversification in building long-term strategic portfolios.

If you would like to read more on this topic you can click here to view Vanguard’s research paper.

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Scramble for yield favours high income global equities

If investor sentiment in 2012 was characterised by a flight to the safe haven of cash and bonds, 2013 is likely present new and different challenges, as interest rates remain at historically low levels and cash struggles to provide acceptable returns. 

Battle weary investors are starting to look further afield and ask where the smart money can find outperformance now.
 
The answer could well be high yielding global equities, says Stephen Thornber, Portfolio Manager at Threadneedle Investments. 

“In the current low yield world, the right global equities have the potential to give investors both a stable source of income, as well as potential capital growth,” he says, “and for investors looking for a reason to exit the save haven assets, that’s a heady mix.”
 
Mr Thornber explained that the move to cash in 2012 was the result of investors trying to mitigate the risks associated with three key global themes; the fiscal cliff, the effect of the leadership transition in China, and the drag of the Eurozone crisis.  

“Any uncertainty unsettles markets, and investors were understandably attracted to the safety of cash and bonds,” he said.
 
This year however, the situation is quite different.  Mr Thornber explained that as 2013 unfolds, fears of impending doom are starting to abate.

“There is increasing optimism about the global economy,” he explained “a compromise was reached on the fiscal cliff, concern over the Eurozone is starting to ebb, and signs are emerging that the Chinese economy is picking up pace.” 
 
However, interest rates remain at historically low levels, and with global economic growth still sluggish, this is unlikely to change in the near future.  Cash will not be able to provide the high returns and income that investors, particularly those heading into retirement, are looking for.  All of these factors have combined to encourage investors back into risk assets such as equities as a means of taking advantage of the potential upside associated with improving global economic conditions.
 
Mr Thornber said that contrary to what some investors might think, global equities have been relatively stable over long periods of time, and that on a yield basis alone, are still holding up well.
 
“And while many high yield assets are becoming more and more expensive, many equities, relatively speaking, are cheap at the moment.  And what makes high yield global equities even more attractive to us is that we are starting to see payout ratios increase in the US, Europe and Asia.”
 
“Following the GFC, many companies sought to protect and consolidate their balance sheets and as a result there was a significant compression in payout ratios.  However, with improved global economic data and stronger corporate profits in many sectors, payout ratios are starting to improve,” he explained.
 
Mr Thornber concluded by saying that he believes investors will continue to rotate into risk assets in 2013, but only where there are prospects of real returns. 

“And that’s where Threadneedle’s Global Equity Income strategies have been able to perform well.  We leverage the insights of colleagues from across the investment floor covering various asset classes to gain a better perspective and understanding of the key macroeconomic developments and themes that are likely to play out. We then pick stocks that meet our yield targets and also provide the potential for sustainable growth,” he said.

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“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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However, bank term deposit rates have fallen and are likely to fall further, possibly to around 4%, as the RBA continues to reduce the cash rate to help the economy. So it makes sense to look elsewhere.

Our view is that the RBA will cut official interest rates from 3.5% currently to 3% or just below over the next six months on the back of sub-par business and consumer confidence, disappointing growth and benign inflation. While the RBA is currently putting out a relaxed and comfortable message it should be noted that it put out a similar message earlier this year only to commence cutting interest rates again in May.

To read more about investments that might deliver a decent yield, click here.

30 July 2012

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This has several implications for investors. A key one is that the yield an investment provides will be a key component of returns going forward. Focusing on investments that offer a decent and sustainable yield provides a greater certainty of return and, for those in retirement, a decent cash flow as well. But what do we mean by yield? Why is it so important? And where can it be found?

What is yield?
The yield an investment provides is basically its annual cash flow divided by the value of the investment.

• For bank deposits the yield is simply the interest rate, eg bank 1 year term deposit rates in Australia are now around 5.7% and so this is the cash flow they will yield over the year ahead.
• For ten year Australian Government bonds, annual cash payments on the bonds (or coupons) relative to the current price of the bonds provides a yield of around 4.4% right now.
• For residential property the yield is the annual value of rents as a percentage of the value of the property. This varies depending on the property, but on average in Australian capital cities is about 4.7% for apartments and around 3.5% for houses. Of course these are gross yields – after allowing for costs, net rental yields are around 2.2% for apartments and 1% for houses.
• For unlisted commercial property, yields are typically around 7% or higher.
• For corporate debt, investment grade yields are typically around 7% in Australia, and lower quality corporate debt yields are higher.
• For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are currently running around 4.7% of the value of the shares. Once franking credits are allowed for this pushes up to around 6.2%. Of course this masks a wide range – bank shares are currently trading on dividend yields of around 9.5%, whereas mining shares are trading around a 2.2% dividend yield.

Yield and total return
The yield an investment provides is important because it forms the building block for its total return. The total return an investment provides is essentially determined by the following. 

                Total return = yield + capital growth

For some investments like cash or term deposits the yield is the only driver of return (assuming there is no default). For fixed interest investments it is the main driver – and the only driver if bond investments are held to maturity – but if the bond is sold before then there may be a capital gain or loss if the bond’s price has changed.

For shares and property, capital growth (or loss) is of course a key component of return, but dividends or rental income form the base. So for example, over the year to June Australian shares returned 11.7% but this was comprised of 7.1% capital growth and 4.6% from dividends.

Prior to the early 1960s most investors focused on yield, particularly in the share market where most were long term investors who bought stocks for their dividend income. This changed in the 1960s with the “cult of the equity”, as the focus shifted to capital growth. It was pushed further through the disinflation of the 1980s and 1990s as falling inflation saw dividend yields pushed lower. It was taken to an extreme during the bull market from the mid 1990s as investors chased share prices higher in pursuit of growth (which in turn pushed dividend yields lower) and there was a greater focus on companies retaining earnings to generate faster future capital growth. Similarly at various points of time – usually when the market is strong – real estate investors have only worried about price gains and not rents.

Why yield matters?
In recent years yield has started to make a comeback and it is likely this will continue in the years ahead.

Firstly, the constrained and volatile ride from global shares over the last decade, and more recently from Australian shares, has led to increased uncertainty about capital growth from shares. This has also occurred in relation to property markets, particularly Australian residential property, with recent volatility (falling home prices in 2008-09, rising prices into early last year and now falling prices again), high house price to income ratios and the slump in house prices in the US and elsewhere all leading to concerns house prices might fall sharply going forward. This has all seen the investor obsession with speculation and growth fade substantially in relation to both shares and property.

Secondly, a high starting point yield for an investment provides some security during tough and uncertain times. In fact, while many have focused on capital growth it’s worth noting that since 1900 more than half of the 11.7% pa total return from Australian shares has come from dividends (ie 6% pa). The importance of dividends is highlighted by the following: $100 invested in Australian shares in December 1980 would have grown to $874 by the end of August based on capital growth alone, but once dividends are allowed for and reinvested along the way this rises to $3213.

In a world of constrained returns from mainstream shares and residential property, yield or cash flow the investments generate will likely represent a higher proportion of total returns going forward.

Finally, as baby boomers increasingly retire, investor demand for income, and hence yield, will likely be high as the focus shifts to capital preservation and income generation. Increased demand for yield bearing investments will likely also benefit their return going forward.

So where can attractive yields be found?
The table below compares a range of investments, breaking down their medium term return potential between that derived from current yields (ie interest payments, rents, distributions or dividends) and capital growth (based on potential nominal GDP growth for shares).

Obviously given the constrained post GFC environment we are now in, there is a greater than normal degree of uncertainty surrounding the capital growth assumptions. By contrast, the assets providing a higher yield generally come with a higher degree of certainty regarding return.
Assets that stack up well in terms of yield right now include: Australian corporate debt, commercial property, Australian equities (once franking credits are allowed for), and infrastructure and bank deposits (although note that bank term deposit rates have been falling recently).

But are yields sustainable – what are the pitfalls?
While there is a strong case for investors to focus on investments offering a decent yield it needs to be acknowledged there is no such thing as a free lunch. When the secular bear market in global shares first commenced last decade there was an intense investor rush for yield. However, this resulted in investments that provided very high yields when conditions were strong but were in fact high risk – eg highly geared sub-prime mortgage debt or heavily leveraged property and infrastructure stocks. So it’s critical when investing in yield based investments that investors focus on opportunities that have a track record of delivering reliable earnings and distribution growth and are not based on significant leverage.
Investors should also realise that just as the higher the return the higher the risk, so too the higher the investment yields the higher the risk.

Concluding comments
There is no such thing as a sure thing in the investment world, but investments that offer high and yet sustainable yields that don’t rely on high leverage provide a degree of confidence they will provide a decent return. Particularly when the ongoing hangover from the GFC is resulting in constrained and volatile investment markets.

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