This is probably the question we get asked more than any other by prospective clients. They have watched their term deposit (TD) rates dwindle gradually from the famous 5 year 8% Westpac TD from late 2008 down to the average of around 1.5% for a 1 year TD today.
A lot of investors would say: “Why is this a problem? Are you not fully invested?” Unfortunately, for SMSF trustees in particular, the answer is “Yes – but that is the problem!” SMSF’s have traditionally kept an allocation to cash (usually held in TDs) at around 25% of their portfolios.
This stems from a number of sources, but the main two are the need for safety with retirement assets which have to last a long time, with memories of the GFC still relatively close, and the fact that as mentioned above, not so long ago TDs offered a decent return.
Not helping is the received ‘wisdom’ of holding 3-years worth of income in cash, just in case of that deluge of a rainy day.
So, the mathematics of the situation make the push into riskier assets in search of income – mainly dividend yielding stocks – an inevitable consequence.
If the goal is to generate 5% income per annum, and 25% of the portfolio yields 1.5%, then simply, the remaining 75% needs to generate 6.17%.
However, if you were to invest 100% of that remaining allocation into a high yielding dividend ETF such as SYI for example, then that would only return 5.71% gross, before the 0.35% management fee. Therefore, having a 75/25 dividend yield/cash split means you can’t meet your income target even with the highest dividend paying stocks as 100% of your equity allocation.
Looking further into the stocks that make up this ETF, the usual suspects are in there – the banks, big miners and insurers – not much diversification there.
So what is (part of) the answer? How do you increase your income without taking all this risk?
The answer is investment grade bonds
Over the last 30 years or so, the bond market in Australia (which is mainly government and investment grade corporate [financial and non-financial] bonds) has returned approximately 2% per annum more than cash.
This is the extra return you get paid for taking the credit risk (the risk you don’t get paid your interest on the due date and don’t get your capital back at maturity) of the corporate issuer compared to a term deposit in a bank.
You can see in the chart below this relationship, and how it has held steady over the long term:
The returns shown in the chart are generated from investing $10,000 on the 1st of January 1990 to the 30th of November 2019 (the latest available data from Vanguard). Over the period, bonds have returned 2.54% per annum more than cash, and typically at any point in the cycle this excess return is between 1.5-2.5% per annum.
Approximately 90% of the current bond index is government risk – either the Commonwealth, States/Territories or foreign government sponsored organisations such as the World Bank – so very little if any credit risk.
This is why we focus on investment grade bonds – for their safety. S&P, the ratings agency, does an annual study of the default history of all bonds in its coverage globally. This shows that in an average 5-year period over the life of the study (currently 36 years), investment grade bonds have defaulted – that is missed an interest or principal payment – 0.92% of the time (which includes government bonds which are considered risk free).
If you focus on the lowest investment grade ratings band, where the highest yields are found, this figure does rise, but only to 1.70%.
In Australia, the record is even better than globally, with only 3 investment grade bonds having defaulted in this period – HIH Insurance (fraud), Pasminco (over-leveraged zinc smelter) and Babcock & Brown (GFC victim). In every single other bond, every single interest and capital payment has been made on the due date.
Download the Deloitte Corporate Bond Report
An investment grade bond portfolio today can yield you approximately 3% per annum, or more if you select the right security mix (e.g. include Residential Mortgage Backed Securities). Our Conservative model portfolio currently yields 2.89% per annum to buy now (as at 31 January 2020) – which can be improved with a bit of patience. See here for further details.
Conservatively using the 3% assumption, which is just 1.5% more than cash, you can see the income demand of the remainder of the portfolio decreases by nearly 0.5%, putting you much closer to the threshold for those higher yielding equities.If you have access to higher yielding products than equities, such as property trusts or other high income investments, then you might even consider reducing your equity risk further and allocating a bit more to safer bonds.
In a downturn your portfolio valuations will thank you twofold – for protecting your capital and securing your income.
We look forward to hearing from you to discuss how we can start improving your returns on cash in a low risk investment grade bond portfolio.