Is the yield game changing?
Summary: Low interest rates have spurred a mass capital migration from cash and fixed interest into higher-yielding equities. Share prices have risen in tandem, and now investors need to be extra careful as some companies are likely to struggle to maintain their yields over the longer term. |
Key take-out: Equity investors should be seeking companies who provide a growing level of profits and dividends. The difficult decision for yield-focussed investors is whether the current prices of equities, particularly bank shares, reflects their bright prospects or their relatively higher yield in the short term. |
Key beneficiaries: General investors. Category: Investment strategy. |
Savers generally, and superannuation investors specifically, are confronted with a disturbing short-term outlook for interest rates.
For the foreseeable future (which I define as up to two years) they are unlikely to be offered a yield on short-term bank deposits (i.e. up to six months) that exceeds inflation. The taxation of interest income outside superannuation makes the return even worse. A negative real yield on cash will push savers and investors to consider higher-risk and volatile investments to generate income flows.
An obvious investment focus has become the listed securities market, because the ease of investment and the range of investment opportunity have improved steadily over the last 10 years. However, the understanding of risk and the exposure to volatility is something that many investors fail to appreciate. The most recent 10 years shown in the chart of Telstra bears this out.
The Telstra price chart (representing a stable high-yielding equity) clearly shows that investors need to take a long-term view. Investors need to appreciate that returns from investment assets can give fairly static and predictable returns over a long period. However, whilst short-term volatility can be a challenge to patience, it can create opportunity for the agile and sensible “value” investor.
My key messages to investors seeking yield from listed securities is as follows:
- Try to understand the economic cycle; focus upon central bank policy and activity; monitor the outlook for inflation.
- Have a sensible valuation methodology, particularly for securities that have significant equity risk or are pure equities.
- Understand what a reasonable return from investing in listed securities is. Be satisfied with a return that represents a small margin above inflation plus GDP over a long period.
- Whenever possible, allow the compounding of investment returns to occur. This is the key to building wealth over a long period. Live within your cash flow means and reinvest as much as possible, even when the bulk of the return from a security is income.
Types of listed yielding securities
These can be summarised as:
- High-yielding equities;
- Convertible (into equity) yielding securities;
- Preference shares;
- Hybrid-yielding securities;
- Corporate bonds; and
- Property trusts
The risk profile of these securities can be shown as follows:
Charts to contemplate in understanding volatility
The first and key chart for investors to contemplate is the Australian 10-year bond rate. Ten years ago the bond yield was about 6% and today it is about 3.7%. In the key period before the GFC, the bond yield was increasing (peaking at 6.8% in early 2008). Despite the rise in the so-called “risk free yield” (and a decline in bond prices), we saw equity prices lift. An equity bubble formed and then imploded.
The Government 5 or 10-year bond yield is commonly regarded as the “risk free” return. This is because governments have historically always repaid their debts and serviced their interest payments. Therefore, the “risk free” term declares that any other investment asset should generate a higher return than the “risk free” return. A rational investor would seek nothing less.
A higher return or a higher margin above the risk free return is required, as more risk is assumed. Investors therefore need to keep a watchful eye on the bond market to determine a fair return from an investment asset.
Another chart to note is the 180-day bill rate. The chart below shows that cash, or near cash yields, are at longer-term lows. This is important because the yields have crashed to below inflation and the opportunity cost of being patient – in the wait for a normal interest rate cycle to reappear – has become painful.
The two charts above show the problem for bank term deposit investors. As longer-term yields fall – across the yield curve – then investors rolling off from high rate deposits are now offered negative real yields. To capture a positive real yield an investor needs to move further out the maturity curve. In doing so, the maturity risk rises. This is simply the risk that arises from locking in a low yield for a long time that may subsequently by swamped by inflation.
This opens up a key issue when investing in equities with a yield focus. Equity investment is a long-term endeavour and an equity investor should be seeking companies who provide a growing level of profits and thus growing dividends. Importantly, an equity investor needs to understand that equity is perpetual with no redemption rights. Therefore the required returns from equity are much higher than from bonds.
That brings me to a longer-term review of pricing history of a few of the favoured (today) listed securities.
Telstra
First there is Telstra, which today sits in most yield-focussed portfolios. The striking thing about the chart above is that it shows that an investor in Telstra for 10 years has merely received a yield return of about 5.5% franked. This is actually a poor return from a listed equity security because an owner of a 10-year bond has generated a 6% return over the same period. The franking credits of Telstra over 10 years have not compensated an investor for the equity risk or the massive volatility in the share price. An owner suffered a 50% decline in value from 2005 to 2010. However, the shares became remarkably cheap in 2010 and have trekked back to about fair value today.
An investor today is offered a 3.7% return from a 10-year bond or a volatile 5.5% franked yield from Telstra. Is the higher yield compensation for by the increased risk of holding Telstra shares? In the past Telstra has struggled to grow its dividend. Is this about to change with the recent lift in dividend?
Commonwealth Bank
The next listed security is Commonwealth Bank (CBA), which has recently reached an all-time high share price of $81. Like Telstra it has had a volatile journey, but importantly CBA has produced a capital gain of 175% over 10 years, or about 12% per annum to add to its average 5% yield. Further, it has grown its dividends consistently over time as its profit has grown.
An investor who noted the lift in bond yields in 2007 would have perceived an increase risk in owning CBA. A decision to sell at $60, when it was priced for perfection in late 2007, would have avoided the massive decline in 2009 as the share price halved and retreated to six-year lows. However, a portfolio that was bolstered by cash in 2009 had plenty of opportunity to buy both TLS and CBA at cheap prices.
Today CBA trades at near enough to $81 per share, after an extraordinary lift in the share price. Readers will note that I believe that this price is excessive, but it is explainable by the current historic low interest rates being offered for bank deposits. Investors are being driven by yield from bank deposits into bank shares.
Therefore, the difficult decision for yield-focussed investors is whether the current prices of equities, particularly bank shares, is a function of their bright prospects or a function of their relatively higher yield in the short term.
Finally, a quick look at the infrastructure stock Transurban. Whilst it has steadily grown its distributions, its share price has essentially traded in the opposite direction to the movement of yields for bank bills. That tells me that Transurban is a pure yield proposition, with the returns to an owner very much driven by the astuteness of the timing of the purchase against the interest rate environment. The chart below suggests the outlook from here, with historic low interest rates, may well be fairly benign.
John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.
* John Abernethy will be appearing at Eureka Report’s ‘Maximising Income for the Future’ conference to be held at Sydney Town Hall on Tuesday May 27: To find out more about the event or book a ticket please click here.