Income portfolio 2014: Less banks and more cash

The income portfolio seeks to sell CBA and drops Ardent Leisure.

Summary: Heading into 2014 the income portfolio is seeking to sell out of the Commonwealth Bank, which has already been sold from the growth portfolio, and has exited from Ardent Leisure with a view to lifting the cash allocation  towards 30%.
Key take-out: The reliance on central banks to manipulate and underwrite markets will be tested in 2014, and the excessive returns generated by the income portfolio suggests it may be time to take some profits.
Key beneficiaries: General investors. Category: Income.

Recommendations:
Ardent Leisure: Underperform.
Commonwealth Bank: Underperform (at $76 or above).

(2013 was a very good year for investors but few investment options returned more handsomely than John Abernethy’s income portfolio, which promised 20 months ago an 8% return per annum. That target may sound modest now, but at the time it was courageous as the markets had endured yet another downturn. As it turned out John more than tripled on his promise, however his challenge now is to review the portfolio. As you’ll see below, like a winning coach with a successful team he has made few changes. But there are two crucial moves of which you must take note. First, for the second week in a row (See John’s review of his growth portfolio on January 22 when he suggested growth investors switch CBA for ANZ) he has called Commonwealth Bank a ‘sell’ once it crosses $76. … at today’s price of $74.35, that trigger is looming. Second, John is already selling out of Ardent Leisure. As John explains, his view is coloured by recent extraordinary developments in the sovereign debt markets as several weaker European countries appear to be “bid up as if there was no risk of default”. It’s in that context John is seeking to raise his cash weighting to almost 30% if he completes the full sale of Ardent and CBA) Managing Editor James Kirby.

Last week I did a six-month review of the growth portfolio, and this week I am undertaking the same for the income portfolio.

The income portfolio was created 20 months ago with the aim of achieving an 8% return per annum. The bulk of this return was expected to come from income, as opposed to capital gain.

The portfolio was designed as a guide to pension fund investors who were seeking income to support their pension payment profile. Further, whilst volatile, the portfolio as a whole was expected to grow slightly in capital value with the pure equity components (e.g. bank shares and Telstra) expected to achieve capital gain over the mid to long term.

Pleasingly, the portfolio has so far exceeded the absolute return target by a wide margin. Further, the portfolio has continued to perform quite well since June 30, 2013. Importantly, there have been very minor adjustments made to portfolio since inception as it was designed with conviction.

Previously, at the end of each six months I have reviewed the portfolio in some depth. In doing so I have signalled to readers my views and developing risks (if any) with the portfolio.

International markets and events

There has been a striking occurrence across world bond markets over recent times that is worrisome (based on history), but currently supportive of Australian yield markets. This feature is the extraordinary rally in “subprime” or “lowly rated” or “near junk” European bonds. Up to last week there has been a substantial rally in bond prices represented by a fall in the market interest rates of Italian, Spanish, Portuguese and Irish bonds.

The first chart shows that Irish bonds, which have recently been upgraded from junk to near junk, have rallied hard in the last six months. News that Ireland had officially escaped from the European bailout regime led to it raising €3.6 billion of 10-year bonds two weeks ago at a yield of 3.5%. These bonds have since rallied to about 3.2%, or about 75 basis points below that which the Australian government has to pay for its equivalent bonds. The Irish government now pays about the same as the US government for its five-year debt. I am not sure what that says about the US, but the Irish cannot believe their luck!

While German yields have been fairly stagnant, the European countries that survive on Germany’s largesse have seen their cost of debt dramatically decline. Observably high net debt ratios of around 100% to GDP have not pushed up the cost of government debt. In an eerie possible rerun of the precursor to the US subprime crisis, we are seeing government bonds being bid up as if they have no risk of default.

In 2007 there was credit wrapping of securitised subprime mortgage debt by insurance groups such as the US giant IAG to create imaginary AAA-rated paper. In 2014 we are seeing credit wrapping of sovereign debt by central banks. It may not create AAA-rated paper (according to rating agencies) but it seemingly does not matter. In 2008 we found that some banks were too big to fail. In 2014 we may well be led to believe that some governments are too big to fail, and hence bond managers are piling in and grabbing yield without concern for a default. They believe that the big central banks of the world, namely the Federal Reserve, European Central Bank, Central Bank of Japan and the Bank of England, will underwrite all the major developed economies.

This perverse view of bond investors will now be tested, as suddenly we witness the collapse in the currencies of many developing economies (for example Argentina and Turkey). In my view there are big central banks that control or manipulate major currencies and the yield on major bonds (dollars, euros and yen), and there is the rest. The recent sharp decline in the value of pesos, rand, lira and hryvnia is a clear example of this! Oh yes, and let’s not forget the Aussie dollar, which is tracking south at a fast rate.

All of the above suggests to me that we are in for another wild ride in 2014, and particularly in fixed income markets. I am not predicting calamity but again warn readers that the excessive pricing of junk bonds is not sustainable. The reliance on central banks to manipulate and underwrite markets will be tested in 2014. Therefore, the excessive returns generated by the passive income portfolio does suggest to me that it may be time to take some profits and raise cash holdings.

Also, there is another uniquely Australian issue developing. The sharply weaker currency is generating a heightened risk of imported inflation, and that suggests that interest rates may rise independent of the actions of the Reserve Bank of Australia.

Portfolio commentary

The portfolio is split between floating-rate securities and high-yielding equity investments. Generally, I remain happy with the floating-rate securities Multiplex SITES Trust (ASX:MXUPA), Australand Assets Trust (ASX:AAZPB) and Seven Group Holdings Preference Securities (ASX:SVWPA) perpetual securities. Each is a security whose distributions are based on a set margin above 90-day (MXUPA, AAZPB) or 180-day bank bills (SVWPA).

While the yields on offer are lower than they were six months ago, I remain happy to hold each in the portfolios. Their current floating yields of above 7.5% are supported by strong cash flows in each company. However, each security is non-rated and perpetual. The decision to continue to hold them is based on the pathetically low term deposit rates offered to investors by banks. These securities are risky and subject to market price volatility, but their yields currently remain attractive.

The bank hybrids represented by National Income Securities (ASX:NABHA) and Macquarie Bank Limited Income Securities (ASX:MBLHB) remain attractive holds, even though their yields have shrunk over the last year. The income portfolio has benefitted from the price revaluation of each security, which reflects their high-quality yield characteristics and the potential for each security to be renegotiated (redeemed at issue price) over the next five or so years. My previous reports have outlined my view that the banks will seek to reset these securities as their weighting in capital ratios declines.

Although Ramsay Health Care Convertible Securities (ASX: RHCPA) continue to offer an attractive running yield, investors need to be cognisant of the omnipresent risk of either a redemption (at $100) or a conversion into expensive shares at a mere 2.5% discount. At present I am holding the position but it is likely that I will seek to switch this position to another security if the price moves towards $106.

The equity securities are now a bit more problematical. I remain happy to hold Telstra Corporation (ASX:TLS) shares for yield and note that the recent asset sales by the company have improved the company’s balance sheet. There appears an increasing likelihood of an higher dividend in the next year or so.

The bank equity positions remain attractive for yield but the current market prices leave little margin of safety. Last week I identified Commonwealth Bank of Australia (ASX:CBA) as being fully priced and exited it out the growth portfolio. Similarly I have decide to take it out of the income portfolio and increase cash weightings.

For now I have decided to hold Westpac Banking Corporation (ASX:WBC) and National Australia Bank Limited (ASX:NAB), as both are screening marginally below my forecast intrinsic valuation for September 2014 based on market consensus earnings.

Spark Infrastructure Group (ASX:SKI) continues to offer an attractive yield for a solid utility asset. Recently the company negotiated a further settlement with the Australian Tax Office and this supports our decision to buy and hold the security.

Ardent Leisure Group (ASX:AAD) has certainly been significantly re-rated by the market and generated an exceptional return for the portfolio. The projected yield has now fallen to about 6% and well below the yield on offer when it was acquired. While the asset operating base has been expanded and diversified over the last 18 months, I am not sure that the quality of those assets is high. Thus I have decided to exit this security at current prices of about $2.

Overall, the cash weighting will increase and I am happy to wait out the current storm that is brewing in fixed income markets to see if we cannot find some new and attractive yield opportunities in coming months.


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

Return since June 30, 2013: 11.03%

Returns since Inception (April 24, 2012): 38.97%

Average Yield: 7.28%

Start Value: $150,754.88

Current Value: $167,388.76

Dividends accrued since June 30, 2013: $5,139.27

Clime Income Portfolio - Prices as at close on 28th January 2014

Hybrids/Pseudo Debt Securities
Company Current Price Margin over BBSWRunning YieldFranking
MXUPA$82.803.90%7.89%0.00%
AAZPB$97.804.80%7.60%0.00%
MBLHB$82.521.70%5.25%0.00%
NABHA$75.001.25%5.17%0.00%
SVWPA$88.104.75%8.39%100.00%
RHCPA$105.504.85%7.10%100.00%
High Yielding Equities
CompanyCurrent PriceDividendGUDYFranking
TLS$5.13$0.298.08%100.00%
WBC$30.85$1.828.43%100.00%
NAB$33.37$2.038.69%100.00%
SKI$1.65$0.116.69%0.00%
Code Value 
Cash $        33,625.74