Investing for income
With interest rates at record lows, traditional yield investments no longer cut it if you want to preserve your wealth
Investing for income in this low-return climate is a big challenge but it's not impossible. If you are fairly risk averse, though, you have a dilemma. Cash rates are 1.5%, term deposits pay around 2.5% and long bond yields are 2.8%. With the Reserve Bank expecting inflation of around 2% over the next year, the return from your cash after tax isn’t keeping up with the cost of living. If you keep a large slab in term deposits paying 2.5%, the net return is 1.3% if you are on the top marginal tax rate. But this is below expected inflation.
To avoid your money going backwards, you need to find income beyond traditional income investments. You also have to work harder at diversifying.
The good news is that if you are prepared to take on some risk and can live with volatility, there are good yields still from Australian shares, Australian real estate investment trusts (A-REITs), select mortgage trusts and high-yielding exchange traded funds (ETFs).
One of the most reliable sources of income comes from the Australian sharemarket, says Don Hamson, managing director of Plato Investment Management. “Although cash and fixed-income investments are
traditionally considered income investments, there is a strong case for investing in equities, particularly Australian stocks, for generating income as well as capital growth,” he says.
The Australian S&P/ASX 200 generated an annual 4.5% cash dividend income over the 10 years to March 31, 2017. Over the same period, you would have received less from cash with the official overnight rate averaging 3.8% while the one-year term deposit rate also averaged 4.5%.
Hamson is a big fan of Australia’s unique franking credits tied to Australian companies’ dividends. “For Australian resident investors, franking represents a credit or refund of company tax paid on Australian company profits. Australian pension-phase superannuation investors currently receive a full refund of franking credits, so franking credits represent extra income,” he says. Dividends have boosted gains from the S&P/ASX 200 to provide a return of 6.1%pa over the 10 years to December 31, 2016, including 1.6%pa franking for tax-exempt investors such as pension-phase superannuants. This is based on the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt).
Plato listed a fund designed to provide monthly fully franked dividends – Income Maximiser (ASX: PL8) – which raised $325.9 million.
Hamson says what most investors don’t understand is that the volatility of dividend income generated by the sharemarket is around half as volatile as the value of the market. For example, with the index level at 5700 you might expect in two out of three years the change might stay within either 1000 points more or 1000 points less.
But the dividend yield, including franking, for the ASX 200 index might be within either 0.5% more or less in a well-diversified portfolio in two out of three years.
“The yield on the Australian S&P/ASX 200 Index has been remarkably stable for the past five years, averaging around 6% per annum on a gross-of-franking basis,” says Hamson.
However, he adds, this is the yield on a diversified portfolio of 200 stocks. “Single stock dividends can be far more volatile. For example, BHP Billiton, once the bellwether Australian stock, cut its dividend by 80% in the 2015-16 financial year.”
But this year BHP increased its interim dividend by 144%. “But the large cut last year highlights the risk of relying on a single stock for dividends.
If an investor only had BHP in their portfolio, their income would have fallen by 80% in a single year,” says Hamson.
He says the big four banks (ANZ, CBA, NAB and Westpac) represent a large portion of the index and have been great yield investments over the past 20 years but all four cut their dividends during the GFC.
Income from Australian-listed real estate investment trusts (A-REITs) is around 4.6%, but the historical average for the sector is around 6.4%. Considering the low rates from cash and bonds, the yield is still fairly attractive.
The A-REIT sector has had five consecutive outstanding years returning 16.24%pa, more than three times 4.87% pa from the Australian bond market. Yields vary widely across the different categories and even within the same broad type of property.
An advantage of A-REITs is their diversification. Instead of holding all your money in one property, A-REITs diversify across a number of different regions and sectors such as retail, commercial and industrial as well as specialist areas such as health, childcare and aged care.
A-REITs are also liquid investments that can be bought and sold easily on the ASX or from a fund manager.
Unlisted mortgage trusts can hold risks for investors because they are not subject to ongoing monitoring by a market regulator. It can also be harder for investors to know what is going on their investment.
Poor experiences with mortgage trusts has meant that ratings houses do not rate many mortgage trusts. One of the exceptions is La Trobe’s 12 Month Term Account (formerly the Pooled Mortgages Fund) which has won eight consecutive annual awards from Money magazine over the years for being the best mortgage fund. It is the only fund that three ratings groups, SQM, Lonsec and Zenith, said was worthy of an award in the mortgage fund category.
The minimum investment is $1000. The fund pays out monthly, suiting people on a fixed income.
The ratings agencies were impressed by La Trobe’s experience, which stretches back to 1952 as a credit specialist. The 12 Month Term Account targets a loan-to-valuation ratio of a maximum 75% and averages around 63%. “We avoid those asset types that have traditionally presented an enhanced risk profile, such as land-banking loans or loans secured by specialised security properties,” says Chris Andrews, chief investment officer.
From these assets, Andrews says La Trobe builds highly diversified performing loan portfolios that have a long track record of generating capital-stable, premium-income returns for its investors, both institutional and retail. “Over 65 years we have never lost a cent of capital for either our institutional investors or investors in our retail pooled portfolio accounts. Over that time we have worked through many different economic cycles and this time is no different.
“At present the banks face increased capital requirements –they need to hold more capital for each loan they write – and are being used as an alternative policy lever by the federal government and their regulator, APRA, which are searching for solutions to issues such as housing affordability. It is likely that these drivers will continue to affect the banks at least into the medium term and reduce the availability of credit for quality borrowers.”
ASIC has developed eight benchmarks and disclosure principles for investors who are considering investing in mortgage trusts. They include checking on the trust’s liquidity (particularly the withdrawing arrangements), borrowings, loan portfolio and diversification. Most importantly find out if there are any related party transactions, examine the valuation policy, lending principles and loan-to-valuation ratios. La Trobe has other income products that pay higher rates but they carry a higher risk profile.