Background
For investors that seek solid levels of income from their assets, something of a regime shift occurred in the last couple of weeks. For the first time in more than a decade, the yield on bonds (green line) exceeded that of equities (dark blue line), as
per the below chart.
Many retirees utilise Australian large-cap equities as a key source of income, and in the days of zero percent interest rates it was not hard to understand why (particularly once factoring in franking credits). However, at this juncture, investors have
an opportunity to de-risk their portfolios and lock-in higher income in a ‘structurally senior’ asset class.
As can be seen from the chart above, it is not often that these yields are aligned, and we would not expect this to stay the case for an extended period. The reason for this is simple – each of these instruments offers a differing level of risk
(and liquidity) and most of the time, this is reflected in appropriate pricing differentials.
The Difference between Coupons and Dividends
The reason why the asset allocation switch from equities to bonds is compelling is because of the structural difference between a coupon and a dividend. A coupon is a contractual payment that needs to be paid, otherwise creditors have the capacity to
appoint administrators to wind up a company. It is not a discretionary payment (other than for limited instruments, such as additional Tier 1 hybrid securities), and the consequences can be fatal (in a corporate sense) if a coupon or bond principal
is not repaid on time.
A dividend, however, is a totally discretionary payment that is up to the board to declare (and, for some companies, subject to third party approvals). Dividends are typically funded from the net profit a company generates i.e. after it has paid all of
its taxes, employees and interest costs. Importantly, these interest costs include the bond coupons mentioned above. If the business runs into a tough spot (or if any expenses increase on account of inflation), the
board will likely lower or cancel the dividend for that period in order to retain capital within the business. This would likely be considered a prudent course of action, although investors that are accustomed to dividends funding their retirements
may not take such a rosy view of the situation!
Risk vs. Return
When different risks are priced the same, it is hard to argue against going into the lowest-risk option. Right now, an investor can pick up a higher yield in an asset class that is structurally senior (or less risky in a wind-up scenario) with the arguable
capacity to outperform in two out of three future economic scenarios (the base case, where growth is relatively flat, and the downside economic case being a recession). What an investor gives up by doing this is the potential for capital growth in
the more risky asset in the remaining one economic scenario (the upside economic case). As Meatloaf once crooned, “Two out of three ain’t bad”.
What about Term Deposits?
Term Deposits are another attractive investment option at the moment. Locking some cash away for a year at a certain 5% is a decent proposition compared with recent years. However, investors need to remember that locking away is a key
part of the deal – if you need access to your cash, you will pay a break fee/penalty that will negate the headline yield to a significant degree.
The other factor to consider is that of reinvestment risk. If the global economy falls into recession in 2024, it is very likely that central banks will begin cutting interest rates to support economic activity and employment dynamics. Term Deposit rates
are inextricably linked to the cash rate, so if the Reserve Bank of Australia (RBA) cuts rates in 2024, the prevailing term deposit rate in one year’s time might be lower than the 5% on offer today, lowering your return over a three-to-five-year
period.
Fixed rate Bonds?
Conversely, buying a three-to-five-year bond today locks in that 5-6% over the life of the bond and is not subject to reinvestment risk within that period. Fixed rate bonds also have the capacity to increase in capital value if yields fall.
As a general example, a standard five-year corporate bond would see an increase in capital value of around 5% if yields fell by 1% across the curve (all else being equal). Including your annual coupon income of 5%, this would deliver a total return of
around 10% for this particular instrument over the period. This is the same environment in which your equity dividend may be under pressure, although equity valuations may increase due to a lower discount rate.
Australian equity valuations are around the average level compared with the last decade or so, while bond yields are back at elevated (cheap) levels:
Australia’s big dividend payers
Australia has a highly concentrated flagship equity index, with four Banks, two Miners, a telecommunications company and a supermarket chain making up the bulk of market value and dividend exposure.
It is widely acknowledged that banks’ earnings growth has likely plateaued due to the near-term peak in the cash rate cycle from the RBA, uneconomic mortgages being written by some on account of excessive competition, expected slowdown in credit
growth and the likely increase of provisions as consumers are hit with a higher cost of living that dents their credit quality.
It is also worth remembering that if conditions meant that CBA needed to lower its dividend, it is very likely that Westpac, ANZ and NAB would be doing something very similar so now it is not just one dividend you are foregoing, it is an entire sector’s
worth of dividends. Same story if iron ore prices fall.
It is fairly straightforward to construct a geographically diversified portfolio within the local bond market, so you are not forced to rely on an equity index full of Australian banks and miners to generate income. Plenty of global champions issue bonds
in Australian Dollars – companies such as Apple, Intel, Lloyds Banking Group, BNP Paribas - that offer uncorrelated economic exposures compared with the concentrated domestic equity market (and remembering the interest paid on bonds issued by
those companies is set for the term, irrespective of their respective performance).
What to make of the recent rise in yields?
To be fair, it is not a foregone conclusion that yields will fall anytime soon. Economists and interest rate strategists are split on the near-term outlook for yields, due to strong employment dynamics and a consumer that is proving to be much more resilient
to interest rate increases than originally thought.
In Australia, recent wage increases as well as multiple instances of union wage deals in the high single-digits are giving new life to long-forgotten economic terms such as ‘wage-price spiral’. Asset price appreciation (equities and property)
is pushing against the tightening in financial conditions that central banks are aiming to engineer, leaving the door open to further rate rises until harder evidence is provided by economic data that the medicine is working.
However, the debate is focused more on where central bank cash rates peak in the near-term rather than the outlook for economies in one to three years’ time. The ultimate economic impact of higher rates, constrained credit provisions and a falling
fiscal impulse have a pretty good track record of delivering slower economic growth – and lower bond yields – over the medium-term.
Conclusion
If you are an investor focused on income, there haven’t been too many historical opportunities where you can switch out of a volatile, riskier income stream into a safer, smoother income stream and not pay for
the privilege. The age-old principle of asset class diversification is unchallenged although tilting to bonds and cash - without giving up any income generation capacity - seems attractive, particularly if the global economy is heading towards an
economic slowdown.