A warning for yield investors

The time for easy gains in the bond market appears to have passed.

Summary: Investors who have parked cash in recent bank hybrid issues should consider them as short-term cash plays. These hybrids offer a higher short-term yield than general market rates, which may be adequate for older retirees but accumulation investors should seek capital growth elsewhere.
Key take-out: Bank shares appear better value than bank hybrids.
Key beneficiaries: General investors. Category: Fixed interest.

Readers will know that I am both ecstatic and surprised by the return of the income portfolio in financial year 2012/13. My targeted return from the portfolio is 8% per annum and so the return over 2012/13 of 27.3% is very satisfying. However, the portfolio did benefit from a sustained rally in yield securities in general and the portfolio correctly identified a few securities (particularly bank shares) which did much better than the broader yield market.    

In reviewing the rally in yield securities it is important for readers to understand the influences that caused this performance.

First, the following chart (Figure 1) shows that Australian bonds rallied strongly over the year relative to US bonds. The lowering of the yield differential between Australian 10 year bonds and US 10 year bonds gave all other Australian assets a positive kick as well. When the risk free yield falls then so does the required return for all other assets and so asset prices rise. The chart hides the fact that US bond yields were at historic low yields of circa 1.5% and so the rally in Australian bonds to about 2.8% took them to historically low yields as well.

Graph for A warning for yield investors

The other positive influence was the flattening of the yield curve for the major part of the financial year. By this I mean the fall in long term yields towards short term yields. At one point the yield on a 10-year Australian bond (2.8%) went below the then RBA cash rate (3%). This has since reversed with bonds yielding close to 4% and the cash rate falling to 2.75%. However, the chase for yield once again lifted the price of all investment asset classes.

Graph for A warning for yield investors

In June, bond markets retreated sharply across the world following the pronouncements (subsequently restated) by Ben Bernanke, regarding the intended slowing of quantitative easing (QE) in the US. As you can see the statements by Bernanke also shook the Australian bond market with yields lifting and prices falling across the curve for 1 year to 15 year bonds.

Graph for A warning for yield investors

Markets have stabilised in July and most yield assets, including bank shares, have recouped their sharp losses of June. However, the warning shots have been fired and this leads me to suggest that the easy gains in yield securities have passed and returns of closer to 8% in 2013/14 are more likely than last year’s performance.  However, to achieve this return we may need to take profits in our portfolio and wait for new opportunities.

Predictions for yields in 2013/14

The gyrations in bond markets here and abroad should certainly be noted by investors. Despite the sharp increase in yields it is still the case that bond yields are still well below historical norms. The advent and maintenance of QE programs continues to create a false yield and so it is my view that bond yields will continue to move higher even if they are blow long term averages.

Indeed the recent pronouncements of the US Federal Reserve and the Japanese Central Bank that they are targeting 2% inflation gives me more confidence in my view that bond yields will rise. If US 10 year rates lift to between 3% and 3.5% then Australian 10 year yields will rise to about 4.5%. Our bonds often trade at 1.5% above US bonds and our weakening currency suggests that higher inflation is on the way.

The RBA may well cut cash rates again in coming months and so the Australian yield curve may well become more positive, the $A fall further and the risk of imported inflation become more acute. Neither of these is positive for Australian bonds.

Warning for yield investors

The sharp lift in long term bond yields have not as yet been reflected in the cost of capital that is being issued by Australian banks. The world’s capital markets have clearly changed over the last 20 years but surely the required returns on risk capital has not. Indeed, it appears to me that the banks are now cleverly accessing the unsatisfied retail demands for yield investments because the world’s debt markets have been totally perverted by massive QE programs. In Australia, the RBA is cutting cash rates and causing a further yield squeeze for investors and savers.

My point is simple. It is clear that the cost of long-term capital should be based on long term bond yields and not short-term bank bill rates. Yet in recent times, we have seen billions of dollars of tier 1 and tier 2 hybrid securities issued by banks that offer very poor long term returns when compared to a bank’s equity. They have done so as bond yields have substantially lifted and as the RBA cut cash rates.

So investors who have parked cash in recent bank hybrid issues need to consider them as short-term cash plays and not as sustainable longer term investments. These hybrids do offer a higher short term yield than general market rates. Further, they may offer be an adequate yield return for older retirees. However, for younger retirees or accumulation investors seeking capital growth, they will be very poor investments. In particular the base yields of these securities are priced off the wrong metric. They should be priced at a high margin above long-term bonds. In my view tier 1 bank preferred capital securities should yield at least 300 points above longer term bonds; therefore their current yields should be over 7%.

In coming to this view I note that bank ordinary shares rank behind tier 1 capital for yield and so their required return is circa 10% to 11% per annum (or 600 points above bonds). In my view a bank hybrid should return between the required return of ordinary equity and the long term bond yield.

Currently bank ordinary shares offer a higher yield and capital growth potential and so to my eye I would rather own ordinary listed bank shares then most of the bank hybrids on issue. So I will hold my bank shares a bit longer until I think they too are overpriced. 

John Abernethy is the Chief investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Income Portfolio Statistics

Returns since June 30, 2013: 2.16%

Returns since Inception (April 24, 2012): 28.34%

Average Yield: 7.51%

Start value: $150,754.88

Current value: $154,011.85

Dividends accrued since June 30, 2013: $0.00

Clime Income Portfolio - Prices as at close on 16th July 2013
Hybrids/Pseudo Debt Securities
Company Current Price Margin over BBSWRunning YieldFranking
High Yielding Equities
CompanyCurrent PriceDividendGUDYFranking

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