Investing for income

5 min read

The search for income is a major driver for many Australian investors, particularly those who have retired.

As official interest rates have slipped over the last decade from 7.25% to a record low of 1.5%, it has become more difficult to generate income1.

Income-seeking investors have usually looked to term deposits, but term deposit rates have decreased as well. As late as January 2011, a three-year term deposit could earn 6.3% from a major bank: now, the average three-year term deposit rate is 2.45%, according to the Reserve Bank of Australia2.

Over the same period, the average rate for a 12-month deposit has fallen from 6.15% to 2.2%, driving income-oriented investors to look elsewhere2.

The option of bonds

Australia, like many other countries has never had an easily accessible retail bond market. Both government and corporate bonds typically traded by wholesale investors in large minimum “parcels,” of $500,000, putting them out of reach of most retail investors and self-managed super funds (SMSFs).

BT’s in-house investment team estimates that a conservative corporate bond portfolio would currently generate somewhere between the Bank Bill Swap Rate (BBSW, currently around 2%) plus 1.5-2% (around 3.5-4%). A higher yielding option such as the Bank of America Merrill Lynch US High Yield Index is currently generating around 6.5%, while bank loans are trading at a spread of approximately 3.5% above the cash rate.

There have also been other measures to open up investment in the bond markets here in Australia. The ASX now hosts fixed income exchange-traded funds (ETFs) and exchange-traded bonds (XTBs). ETFs offer investors access to portfolios based on benchmark indices of government, semi-government and corporate bonds from Australia and overseas, while XTBs have opened up access to the performance of domestic investment-grade corporate bonds, with the transparency and liquidity of the ASX. The important feature of both fixed-income ETFs and XTBs is that investors can invest, or sell, any amount at any time.

The idea of REITS

Another traditional source of income for retail investors has been real estate investment trusts (REITs), which are listed on the ASX. REITS were formerly known as listed property trusts (LPTs), or unlisted property trusts and syndicates. According to specialist property investment manager, Phoenix Portfolios, Australian REITs (A-REITs) are currently offering income yields in the region of 5.8%, with a distribution yield of around 4.8%3.

On the unlisted side, there is large variation in quality and sectors. In the higher yielding sectors, Phoenix have seen many syndicates offering a dividend yield of around 7% but with little capital growth. Residential property yields are trending below 3% in most cities, though Brisbane and the Sunshine Coast have offered slightly higher returns.

Infrastructure is also an asset class that Australian investors have looked to for income yield. Infrastructure assets are generally viewed as stable, defensive, long-term cash flow generators, with the potential to offer protection against inflation. According to Zenith Investment Partners, an Australian retail research firm, investors using a fund investing in global listed infrastructure securities could expect an income yield of 4–5% a year, while funds investing in direct infrastructure assets may generate a higher yield.

Shares and dividends

Australian investors have become accustomed to using shares as income-generating investments, making use of the attractive attributes of the dividend imputation system. In particular, a self-managed superannuation fund (SMSF) operating in accumulation phase, with a tax rate of 15% on earnings, receives a partial rebate of the franking credits attached to a fully franked dividend, because it does not need all of the franking credits to offset tax on the dividend.

An SMSF in pension phase (paying pensions to members), with no tax on its earnings, receives a full rebate of the franking credits, because it has no tax to offset. For SMSFs, the dividend imputation system ensures that a dollar of fully franked income is effectively worth more than a dollar. SMSF investors have used these rebates to great effect to augment dividend yields.

However, there are several aspects to using share dividends for income that must be understood.

The first is that equity dividends come out of company earnings, and are not certain in any financial year. The company can cut the dividend, without warning; in extreme cases, it can simply not pay a dividend. Even the stocks most used for income investment, the big four banks and Telstra, have had occasion to cut their dividends.

The income potential of dividends

The second quirk for investors using the stock market for income is that share dividend yields change with share prices, being the yield on a certain dividend amount rises as the share price falls, and falls as the share price rises. Changes in share prices, and dividends, can have a positive or negative effect on the investor’s outcome depending on the circumstances.

When your client buys a stock, the price they paid will determine the yield that the dividend represents to them. Regardless of the yield quoted on the stock in the newspaper or online, whether it uses historical (last year’s paid dividend) or projected (analysts’ consensus estimates) dividends, the eventual yield on a stock is determined by the buying price, not what happens to the share price after that.

For example, say a particular share trades at $30 and offers a FY18 dividend of $1.90. This would equate to a yield of 6.3%. While this may be attractive to a yield-oriented investor, if an investor bought the share for $10 in 1999, they would realise a yield of 19%.

That is the positive impact of a growing dividend stream. But the same effect can work in reverse, if a dividend stream suffers a setback. Investors take capital risk to gain (and maintain) access to share dividends.

Consider the example of Telstra. In May 2017, Telstra was trading at $4.40. On the expected 31 cent dividend, it was yielding 7%, fully franked.

In August 2017, Telstra announced that it would pay out between 70%–90% of earnings in dividends, rather than close to 100%. It was the first major change in dividend policy since the telco was floated by the government in 1997. On that basis, Telstra's pay-out to shareholders could be expected to fall to about 22 cents, fully franked, as the company tried to weather the impact of the national broadband network (NBN) on its profits. At 22 cents, the new expected yield (at $4.40) was 5%.

A year down the track, and Telstra is trading at $2.88, an expected FY18 yield (on a dividend of 22 cents) of 7.7%. But for that yield, an investor who bought the shares 12 months ago has experienced a 35% capital loss.

There is risk attached to most income-bearing investments, and income-oriented investors must factor that risk into portfolio decisions. Even term deposits bear significant reinvestment risk, as interest rates may have changed during the term. The only income-bearing investment that does not carry risk is a government bond held to maturity, but even that bears risk if it has to be sold at any time before that.

1. Reserve Bank of Australia cash rates
2. Reserve Bank of Australia
3. Phoenix Portfolios offer investment strategies which have been used as part of the property and diversified managed funds offered by BT Investment Solutions. This information has been quoted with permission.
 

BT offers a range of investment solutions for your clients, including those with an income-orientation.
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Information current as at 28 May 2018. This document has been prepared by Westpac Financial Services Limited (ABN 20 000 241 127, AFSL 233716). Past performance is not a reliable indicator of future performance. This article provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to your personal objectives, financial situation and needs having regard to these factors before acting on it. This article may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material. Any tax considerations outlined in this article are general statements, based on an interpretation of the current tax law, and do not constitute tax advice. Superannuation is a means of saving for retirement, which is, in part, compulsory. The government has placed restrictions on when you can access your investment held in superannuation. The Government has set caps on the amount of money that you can add to superannuation each year on both a concessional and non-concessional tax basis. There will be tax consequences if you breach these caps. For more detail, speak with a financial adviser or visit the ATO website. Westpac Financial Services Limited and some of its related entities may have invested in the past, currently or in the future, in some of the shares and bonds referred to in this document. ©Westpac Financial Services Ltd 2018