Flight to high-yielding stocks needs a careful approach

High-yielding stocks might not be the pot of gold investors are seeking despite the latest official cash-rate cut by the Reserve Bank further reducing the attractiveness of cash and term deposits.

High-yielding stocks might not be the pot of gold investors are seeking despite the latest official cash-rate cut by the Reserve Bank further reducing the attractiveness of cash and term deposits.

The global search for yield amid falling interest rates has increased over the past year, boosting the local stocks of banks and other defensives. Shares in Commonwealth Bank hit a record high of $74.21 last month, and have doubled their value since the RBA started its current monetary easing cycle in November 2011. The cash rate has fallen by 225 points during the same period.

The bank's price-to-earnings ratio stood at about 16.16, with an indicative gross yield of 7 per cent. Analysts are expecting a dividend rise when the bank releases its full-year results next week.

"The cash bubble is going to burst," Bell Potter analyst Charlie Aitken said about keeping money in cash deposits. He said with the lower cash rate, after-tax returns for cash deposits could be 0 per cent at best or head into negative territory.

In contrast, a high-yielding dividend stock such as Telstra could provide investors with after-tax real returns of between 2.21 and 6.07 per cent, Mr Aitken said.

Telstra shares have soared by almost $2 to $5 since November 2011. The company issued a final fully franked dividend of 28¢ a share in August last year and an interim dividend of 14¢ a share in February this year.

"When the fear of no investment income meets the fear of missing out, you get big-risk asset price moves," Mr Aitken said.

"This coincides with a period where I believe the level of cash being held can only head one way, down, and the level of confidence in the broader business and household sector can head only one way, up."

But as the economy weakens amid a rebalancing away from mining-led growth, the soaring prices of yield stocks might not be backed by earnings growth, leaving such shares more vulnerable to selloffs, equity strategists said.

"Not all yield is going to be defensive, like putting your cash in the bank," Credit Suisse analyst Damien Boey said.

"The issue here will be - should the economy slow down and should GDP growth go down to 1 or 0 per cent, will these companies be able to sustain the yield that they are currently offering?"

Patersons Securities analyst Tony Farnham said banks could be hit by increased bad debt expenses amid a softening economy, which would decrease banks' profitability and, in turn, their dividend levels.

Other high-yielding stocks such as the big consumer staples companies could be affected by rising unemployment, which would lead to reduced spending by customers and narrow potential earnings growth, he said.

Another factor at play was bond yields, UBS equities strategist David Cassidy said, pointing to the risk of bond yields moving in the opposite direction to cash rates.

At the longer end of the yield curve, US bond yields - followed by Australian bond yields - have risen amid speculation the US Federal Reserve is set to wind back its bond-buying program.

Investors have also scrambled out of the bond market, with the world's biggest bond fund, the Pimco Total Return fund, recording a $US7.5 billion outflow in July, according to Morningstar.

It was the fund's second-biggest monthly outflow.

"I would be cautious about getting too bullish on high-yielding stocks because of that bond yield risk," Mr Cassidy said. "I think one trap potentially is if you get further rises in US bond yields, you'll also see a back-up in Australian bond yields over time."

Mr Boey said as investors weighed up yield, they needed to consider the quality and sustainability of that yield. Investors had to become comfortable with a lower-return environment, he said.

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