Hitting the yield switch

Lower yields from pure income securities means it’s time to reconsider equities streams.

PORTFOLIO POINT: Australian equities still represent fair value, and conditions point to more upside. Consider assets with growing income streams.

Despite the litany of international economic concerns that confronted investors in late 2011 and early 2012, it now appears that the Australian sharemarket index will show a positive 10% return over this calendar year.

The key support factor for the market has been the powerful rally in our bond market. The repricing of equities has been in the face of flat earnings or downgraded expectations, declining commodity prices and a strong Australian dollar. Earnings growth across the broader market has been subdued, and so the recent share price increases reflect an expansion of price to earnings ratios (PERs). This seems logical as PERs have historically increased in response to lower bond yields. Had there been earnings growth, the sharemarket may have produced a much more significant return.

Whilst this year has produced a positive investment return, over the last two years the Australian equity market (including dividends) has produced a negligible return. However, investors who have had a judicious stock selection process focussed on profitability (high return on equity) and/or a focus on sustainable yield have been well rewarded. More recently, since the creation of my two portfolios back in April, the returns from both listed equities and income securities has been impressive.

My view is that the process of PERs expansion and yield chasing still has some way to go.  This is because the forces that have acted to push bond yields down and PERs higher are still in place. Specifically the maintenance of quantitative easing in the US (QE3) and the proposed massive QE to be undertaken by the European Central Bank will continue throughout 2013. Meanwhile there is no end in sight for monetary printing in the UK and Japan.

These forces have not only driven our bond prices higher (lower yields) and resulted in a rise in the prices of investment assets, they have also resulted in a sustained rise in the Australian dollar. These observations or explanations lead me to pose the important question as to whether equity and securities markets are moving into a bubble or a liquidity trap?

In my opinion equities are not at an elevated level to worry “value investors”, and this is particularly so in Australia. While discounts to value are difficult to find in the quality end of our equity market, I believe that Australian equities generally represent fair value. Further, should the A$ decline due to Reserve Bank intervention and/or a sustained recovery in the US economy becomes apparent, then the Australian sharemarket would seem well positioned for further gains in 2013.

As for listed income or debt securities, I think that there is a developing and early stage risk element to this market. Think of it in this way – should there be an economic recovery cycle, then there is a risk that bond yields will rise. This is important because it is bond yields (the risk-free rate of return) that determines the yields or value of other income assets. From this point it is absolutely predictable that in say three to five years that bond yields will be higher than today’s historically low yields. This prediction is made for a few reasons, including:

1. The current bond yields are historically low and partly represent extreme risk aversion, caused by the memory of the GFC by investors;

2. Low bond yields may indicate a perception of a risk of recession, or it may indicate the perverted effects of monetary printing;

3. Economic recovery will offer investors significantly better returns from equities than low-yielding risk-free assets. Capital will naturally flow out of bonds to better returning assets;

4. Economic recovery will lift the likelihood of inflationary expectations and devalue bonds; and

5. Economic recovery will see the end of QE policies and the end of excess liquidity.

So my message is clear; investors need to consider whether their income focussed portfolios actually now need more equity securities and less pure income type securities. While I do expect further gains in my income portfolio, I believe that the solid revaluations seen over the last six months require a reappraisal of the structure of my income portfolio.

In a few weeks I will review the whole income portfolio and consider some security rotations. These are unique times and portfolio management needs to be dynamic in its approach. Massive quantitative easing, large fiscal deficits, chaotic currency markets and extremely low interest rate settings worldwide are unique economic events. There is no historical precedent for these times that we are living in. Importantly, observations and reflections of past periods offer little help except in one important respect. Recovery always follows a downturn.

This current environment clearly concerns many retired investors. It is easy to observe how uncertainty is driving investment decisions and the pricing of income securities.

Economic conditions are never static and the chance of economic recovery from now is actually more likely than economic calamity. That is not good for bonds longer term, and so be careful not to overpay for income streams. Whilst the income flows may not decline in the future, the value of that flow will change and that is the risk that many investors are not appreciating at present.

It may well be time to consider investment assets that offer growing income streams. Even more when that growth, like now, is hard to see.


John Abernethy is the chief investment officer at Clime Investment Management. If you’re a sophisticated investor, wholesale investor or have $500,000 or more to invest, Clime are offering you the opportunity to discuss your portfolio and investment options with John Abernethy. Click here

Clime Income Model Portfolio

Return since June 30, 2012: 12.78%

Returns since Inception (April 24, 2012): 12.57%

Average Yield: 7.81%

Start Value: $118,757.19

Current Value: $133,930.55

Clime Income Portfolio - Prices as at close on 6th December 2012

Hybrids/Pseudo Debt Securities
Company Market Price Margin over BBSWRunning YieldFrankingTR (%)
ANZHA$104.002.75%5.63%0.00%6.40%
MXUPA$81.503.90%8.59%0.00%13.56%
AAZPB$95.804.80%8.25%0.00%9.67%
MBLHB$69.001.70%6.96%0.00%17.86%
NABHA$72.221.25%6.02%0.00%8.20%
SVWPA$84.504.75%9.27%100.00%7.34%
WOWHC$106.153.25%5.98%0.00%4.04%
RHCPA$104.994.85%7.55%100.00%8.22%
High Yielding Equities
CompanyMarket PriceFY13 DividendGUDYFrankingTR (%)
TLS$4.35$0.289.20%100.00%24.50%
AAD$1.44$0.128.33%0.00%13.31%
CBA$60.36$3.488.24%100.00%19.50%
WBC$25.47$1.739.70%100.00%19.14%