Taking stock: How we beat our own targets (Part II)

After setting a target annualised return of 8%, the income portfolio has delivered 46% over two years.

Summary: The insatiable hunt for yield by Australian investors over the last two years has helped deliver spectacular returns for the Clime income portfolio. When it was started two years ago, the goal was to achieve an annualised return of 8% per annum. It has far exceeded that target, achieving a return of more than 46% over the two years.
Key take-out: Income security markets are likely to be held at elevated levels for the medium term, with the next move in Australian cash rates likely to be up but still some way off. The securities in the income portfolio will remain well sought after for most of the remainder of 2014, but the outlook beyond this year suggests the exceptional gains that have been recorded are not repeatable.
Key beneficiaries: General investors. Category: Shares.

Last week I closed off the Clime growth portfolio after two years. The initial goal was to achieve a compounding return of 10% per annum, but the portfolio exceeded our targets in returning an impressive 26%. See Taking stock: How we beat our own targets.

This week I am also closing off the Clime income portfolio. When it was created back in April 2012 I expected to achieve an annualised return of 8% per annum. The bulk of the return was expected to be achieved from income, with a smaller return from capital gains as selected securities rerated.

Two years on I am pleased to report that the income portfolio has well exceeded my projections and achieved a return of more than 46% over the two years. At its close, the portfolio retains 19% in cash and it has not been fully invested over the last six months.

The portfolio was a clear beneficiary from the squeezing of yields that is apparent across the western world. The major central banks have been relentless in their attempts to stimulate economic growth and hold down the cost of debt to highly indebted governments. The success of central banks in their endeavours has led to the extraordinary returns in the income portfolio. I also think there has been some fairly judicious security selection along the way.

That is the past, and so what is the outlook from here? I propose to review the portfolio and to give a view on where I think the securities in it are heading. However, before I do so, I think it is important to touch on the current absurdity on display in world debt and bond markets. This leads me to suggest that yield compression will stay for the rest of 2014.

International debt markets are corrupted

International debt markets are a mess with quantitative easing, and are now unable to logically price risk. This was again on display when Greece, with its official junk credit status, re-entered debt markets and raised over €2 billion of 5-year bonds at a yield of about 5%. Remarkably, it was reported that bids for about €21 billion were received for these bonds.

This episode shows the absurdity present in international bond markets and the confronting outlook for yield-focussed investors.

Greece raised its debt despite its disastrous economic position, characterised by the following:

  1. Over the last five years its real GDP has declined by 23.5%;
  2. Its gross domestic debt is forecast to reach 177% of GDP this year;
  3. Its unemployment rate is 26.7% and youth unemployment is over 60%;
  4. The non-performing loans of banks represent 38% of their assets;
  5. 2.3 million households have tax debts that they cannot service; and
  6. 48.6% of households state that pensions are their major source of income.

Clearly the investors in these bonds have security coming from somewhere other than the indebted Greek Government. This security for income and redemption comes from an explicit guarantee from the European Central Bank that European governments (and thus Greece) will not default on bonds held by private investors. The purchasers of the 5-year Greek bonds also drew comfort from the fact that 80% of Greece’s current bonds on issue are held by European member states and the International Monetary Fund.

Pursuant to the first two Greek bailouts. these bonds are not due to be repaid until 2023. The purchasers of the 5-year bonds will be redeemed before the bulk of Greek debt matures. Call me sceptical but this recent bond issue appears necessary to pay the interest on the previously issued bonds. It is a classic Ponzi scheme that has no end in sight.

Interest rates to stay low for much longer

When you soberly review the farce of overseas economies and the perversion of interest rates then it is a logical call to suggest interest rates will stay low across major economies for quite a while longer. Major economies cannot pay high interest rates on their massive debt unless growth or inflation reappears.

Here in Australia the Reserve Bank is thus in a total bind. It cannot independently move cash rates too far against offshore rates. The Australian dollar is already too high and the RBA is cognisant that a revaluation back towards parity will flatten the Australian economy.

Against this backdrop of international markets I will briefly comment on the securities that remain in the income portfolio. In doing so, I recommend that readers review some of the extensive commentary produced on each security over the last 12 months:

  1. I have commented on most of the pure holdings of shares recently. I retain my view that the banks are fairly fully valued but continue to be supported by their yields. Pursuant to StocksInValue.com.au analysis, National Australia Bank Limited (ASX:NAB) is better relative value than Westpac Banking Corporation (ASX:WBC).
  2. As for Telstra Corporation Limited (ASX:TLS), I outlined in my recent commentary that the lift in dividend was a bonus for shareholders that was not really supported by profits. However, the dividend is well covered by cash flow (including NBN payments) and thus its share price is well supported by yield.
  3. Spark Infrastructure Group (ASX:SKI) has performed as projected when I brought it into the portfolio about eight months ago. The current yield of about 7% is adequate and I believe the stock is worth holding unless it moves well above $1.80. 
  4. Generally, I remain very pleased with the hybrid portfolio and still believe that each security can be held at current market prices. The pick of them remain NABHA and MBLHB, which have produced excellent returns for the portfolio. I still maintain that these perpetual securities will be renegotiated in a few years and create a small windfall for patient holders.
  5. Australand securities (ASX:AAZPB) rallied hard over recent months after Stockland Group Limited (ASX:SGP) acquired 20% of the ordinary shares. Should Stockland acquire Australand then AAZPB will likely be redeemed or renegotiated at $100. Therefore the security is a hold for now.
  6. The perpetual Multiplex Sites (ASX:MXUPA) are now offering a better yield than AAZPB for similar risk. The current floating-rate yield and the market price that is well below the $100 issue price does support its retention at present. It remains a hold until its running yield falls below 7%.
  7. Similarly, I retain a solid hold on Seven Group preference shares (ASX:SVWPA) with its current attractive pre-tax yield that is paid half yearly. The pre-tax yield remains attractive.
  8. Finally the Ramsay Healthcare hybrids (ASX:RHCPA) are the ones that need to be monitored. The running yield is adequate but there is growing capital risk from a redemption (at $100) or conversion into rather expensive Ramsay Healthcare ordinary shares. Once again I would suggest that prices above $106 would lead me to consider selling this position.

Conclusion

Looking forward, I have no doubt that the exceptional gains recorded from income securities are not repeatable. Projecting forward the outlook post 2014 is far more problematic. While I suspect that the next move in Australian cash rates will be marginally up, I do not see this coming for another 12 months or so. So income security markets are likely to be held at elevated levels (relatively low yields for risk).

At present I believe that the securities in my income portfolio will remain well sought after for most of the remainder of 2014. There currently appears to be limited capital risk given the perverse cycle.

The alternative interest rates offered by bank deposits are at historic low levels, do not match inflation and attract tax away from outside pension fund investors. Therefore, I suggest that followers of the income portfolio hold positions.

In the future I will continue to write for Eureka Report, with one of my focus areas being the macro factors that could affect the value of Australian listed securities.


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.

Clime Income Portfolio Statistics

Return since June 30, 2013: 16.40%

Returns since Inception (April 24, 2012): 46.23%

Average Yield: 7.17%

Start Value: $150,754.88

Current Value: $175,479.22

Dividends accrued since June 30, 2013: $8,172.58

Clime Income Portfolio - Prices as at close on 22nd April 2014
Hybrids/Pseudo Debt Securities
Company Current Price Margin over BBSWRunning YieldFranking
MXUPA$83.863.90%7.83%0.00%
AAZPB$98.494.80%7.58%0.00%
MBLHB$84.501.70%5.17%0.00%
NABHA$78.381.25%5.00%0.00%
SVWPA$88.824.75%8.43%100.00%
RHCPA$105.814.85%7.17%100.00%
High Yielding Equities
CompanyCurrent PriceDividendGUDYFranking
TLS$5.14$0.298.06%100.00%
WBC$35.29$1.827.37%100.00%
NAB$35.49$2.038.17%100.00%
SKI$1.75$0.126.88%0.00%
Code Value Weight %
Cash$33,625.7419.16%

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