A New Approach to Income in a World of Low Interest Rates

Transcription

1 Equity Income: A New Approach to Income in a World of Low Interest Rates New Zealand Equity Research March 2012 craig@harbourasset.co.nz With interest rates globally and locally falling over recent years, and forecast to stay low for some time, investors are finding it more challenging to source adequate income from traditional investments such as term deposits, bonds and cash. A well constructed portfolio of New Zealand and Australian equities can provide investors with an alternative source of income, and the potential to grow the real capital base. Relative to other developed markets, New Zealand has over the long-term paid a high dividend yield. In the 10 year period to 31 December 2011 dividends contributed the majority of the total return. The picture is not too dissimilar for the Australian or US market. Companies in Australia and New Zealand are generally in a good financial position post the Global Financial Crisis (GFC). Many companies potentially have surplus cash on the balance sheet and are either returning capital to shareholders via dividends or undertaking other capital management initiatives. Harbour has launched an Australasian Equity Income Fund which follows a quantitative and fundamental investment process in selecting a diversified portfolio of companies across the New Zealand and Australian markets. We believe that used in a balanced portfolio, this approach should provide investors with an attractive level of income with some capital growth relative to traditional income asset classes. Do we need to rethink how investors generate income from their investments? Investors have historically generated income in their portfolios using fixed income and cash investments, and diversified their portfolios by investing in equities and real assets such as property and commodities. 1

2 This balanced approach has placed bonds at the low end of the risk spectrum and equities at the high end. Traditionally, investors have considered bonds (and cash) as their income generating asset classes, and equities as providing a source of long term real capital protection. Over the very long term, equities have actually done a good job of protecting wealth after inflation and tax. In New Zealand in recent year s finance companies, property companies and term deposits have also provided sources of income, albeit in some instances not without risk. Some investors also typically hold five to ten stock equity portfolios which may provide suitable levels of income, however in our opinion can be associated with a high level of specific (or idiosyncratic) risk. Several significant forces are changing the way we think about balanced portfolios. First interest rates are near record lows it is getting harder to generate real after tax and fee returns from cash and bond portfolios. As a result, investors now face a reducing income stream from their portfolios as the traditional sources are failing in providing sufficient returns to meet the investor s income needs. Secondly, equity market valuations seem attractive and the equity market is yielding a lot more than term deposits or corporate bonds. Third, pooled Portfolio Investment Entity (PIE) funds have attractive efficiency and tax characteristics for many New Zealand investors. How do cash and bond yields today compare to those of the past decade? Currently yields for New Zealand cash, term deposits and bonds are substantially lower than at any time over the last 10 years. For instance, corporate investment grade bonds have had an average yield of 6.8% 1 over the past decade, while bank term deposits have averaged about 5.8%. Today, the running yield on corporate bonds is about 4.6% and six month term deposits are about 4.1%. A similar picture is apparent in the US and Australia. Following the GFC and the cutting of interest rates globally, yields on traditional sources of income have plummeted and the outlook is for interest rates to stay low, with central banks globally providing loose monetary policy to bolster anaemic economic growth. Quantitative Easing by many central banks is helping keep the short end of the interest rate curve at low levels as an example the Fed has stated that overnight rates will stay at 0.25% until the end of Source: NZX Corporate A Grade Index 2

3 "Cash" 3 Month T-Bill Yields US Australia NZ "Short-dated Govt Yields" 2 Year Government Bond Yields US Australia NZ % 5.0 % Jan 00 Jan 03 Jan 06 Jan 09 Source: Bloomberg 0.0 Jan 00 Jan 03 Jan 06 Jan 09 Source: Bloomberg How do equity yields today compare to the past decade? Equities yield more today in New Zealand and Australia than they have in the past 10 years. After taking into account imputation credits, the New Zealand market today yields 7.2%, compared to the last decade average of 6.8%. In Australia, the gap for the Industrial market is even wider; with the average non-resource stock yielding 6.0% (excluding franking credits) compared to the last ten year average of only 4.8%. Asset Class Yields 10.0% 9.0% 8.0% 7.0% Average 10 yr Yield Yield at 31 Dec % 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Source: Harbour, Bloomberg, 10 yr average yield to 31 Dec 2011 How can you get both income and capital returns from equities? Companies generally pay dividends during the year to reflect their after tax earnings. In New Zealand, investors also get an imputation credit associated with the tax paid by the 3

4 % p.a. company. This imputation credit can be used by New Zealand investors to offset tax liabilities. In addition, the value of a share can go up and down. Even if an investor holds onto the share for the long term, in effect in each period (say a year) there is a capital gain or loss that contributes to the total return for that stock. The following chart illustrates what the components of return look like for equities over the past 6 decades (assuming we had enjoyed imputation credits for that length of time). Note past returns may not provide an appropriate guide to future returns Average Components of Historic NZ Equity Returns 1950 to Equities dividend yield Capital Growth Imputation Credit Gross Equity Return Source: Harbour The following table highlights particularly in the New Zealand market how much dividends have contributed to the overall return in the past decade. In Australia over the same period dividends have been important in forming the overall return but less so than in New Zealand. Capital growth has also been a feature. 10 Year Equity Market Returns % P.A NZX50 NZ Property ASX 200 ASX Industrial ASX Resource Average 10 yr Yield Capital Growth (1.2) Total Return Risk - Std dev Imputation p.a 1.8 n/a n/a n/a n/a Source: Harbour, Bloomberg. Data to 31 Dec 11 4

5 In Australia overall return data can be clouded by the influence that the resource sector has on the data. As shown in the previous table, capital growth has formed a greater portion of the resource sectors total return given the need to re-invest in new projects and equipment rather than pay a high level of distribution to shareholders. The message from this is that there are many sectors in Australia where investors can receive both solid income and capital returns. Delving further into the New Zealand market returns, we have looked at data from 1993 to 2011 and disaggregated the components of the dividend return as displayed below. The gross dividend yield has averaged 6.9%; cash yield 5.0% and imputation 1.9% p.a. The imputation credit regime has also provided investors with an additional return uplift. Components of NZ Equity Market Yields 12.0% 10.0% Annual Cash Yield Annual Imputation Annual Gross Yield 8.0% 6.0% 4.0% 2.0% 0.0% Jun 93 Jun 96 Jun 99 Jun 02 Jun 05 Jun 08 Jun 11 Source: Goldman Sachs, Harbour The NZ market has for a long time paid a high dividend yield, particularly relative to other developed international markets. In the 10 year period to 31 December 2011 dividends contributed the majority of the total return. The picture is not too different for Australia. Data from the US also shows a similar experience albeit not to the same extent. Since the 1930 s dividends have on average contributed more than 50% of the total return of US equities 2. We do not see this high level of market dividend yields changing too much in the foreseeable future in New Zealand or even Australia. If anything market dividend yields may increase with the proposed listing of the SOE electricity companies plus the recent splitting of the Telecom business, all of which may provide reasonable yields. 2 Source: Strategas 5

6 % p.a. Are equities riskier than bonds? Yes. Using annual return data, equities have much higher risk on average than bonds. However, when looking at investment returns investors need to consider also both the time horizon of their investment and the effects of inflation. Capital preservation and growth of the asset base are important considerations in addressing investor s long term investment goals, alongside any short term income requirement. Looking at 110 years of return data, NZ income asset class returns have provided returns on average between 5-6% per annum. However once we take adjust for inflation, real income returns have only been about 2% per annum NZ Income Asset Classes 1900 to 2010 Cash Bonds Inflation Real CashReal Bonds Source: Credit Suisse Global Investment Returns Source Book 2011 If we then consider equities in the same context the differences are quite marked. Not only is the total return close to 10% p.a. but an investor has received a real return which has grown the capital base significantly. Inflation risk over the long term can be significant. $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 Compound Returns 1900 to 2010 The value of $1.00 invested in 1900 $6.40 $8.80 Real $ $600 $500 $400 $300 $200 $100 $0 Source: Credit Suisse Global Investment Returns Source Book

7 Annual Return % Bonds are typically viewed as being relatively low risk due to the lower variability of their returns. However, they can provide in certain occasions a large negative or positive annual return as when yields rise or fall a bonds market value can vary significantly. If we consider however 10 year bond returns, then the range and average return is more in-line with what expectations would be for bonds What Is The Risk of Bonds? Yr Averages Highest Lowest Average Bond Annual Returns Bond 10 year Returns Source: Credit Suisse Global Investment Returns Source Book 2011 Equities are inherently more volatile, and the range of returns over the past 60 years has been large. However if we look at average 10 yr period returns the risk of equities is less so, and over the last two decades New Zealand bond and equity index returns have been similar. 40% Average NZ Equity & Bond Index Returns (Over 10 Years) 35% 30% Bonds Equities 25% 20% 15% 10% 5% 0% Dec 60 Nov 67 Nov 74 Nov 81 Nov 88 Nov 95 Nov 02 Nov 09 Source: Harbour, NZX, Russell, JB Were, NZ Statistics Department 7

8 Why do equities yield so much today relative to bonds? At end of February 2012 the New Zealand 10 year bond yield was around 4% and yet the prospective NZ equity market dividend yield is close to 7%. 10% NZ Forecast Equity Dividend & 10 Year Bond Yields 9% 8% 7% 6% 5% 4% NZ Equity Dividend Yields NZ 10 year Bonds 3% Jun-92 Jun-96 Jun-00 Jun-04 Jun-08 Source: Harbour, NZX, Russell, JB Were, NZ Statistics Department This high yield in equities implies that investors are either nervous about future growth in company earnings and dividends or are extremely risk averse and are demanding a much higher Equity Risk Premium. In fact, we know that investors actually expect a better outlook for company profits in 2012 and higher dividends both this year and next year. 8.0 Australian Forecast Net Dividend Yields 8.0 NZ Forecast Net Dividend Yields % 5.0 % FY1 DPS/current index level FY2 DPS/current index level Historical 12m dividends/curent index level Mar 03 Mar 05 Mar 07 Mar 09 Mar 11 FY1 DPS/current index level 3.0 FY2 DPS/current index level Historical 12m dividends/curent index level 2.0 Mar 03 Mar 05 Mar 07 Mar 09 Mar 11 Source: Harbour, Bloomberg, NZX Therefore, we can imply that investors instead are really demanding a much higher risk premium from equities as there is a sense of panic and risk aversion in markets. We can see that from the following global chart that many investors are concerned about global equity risk. 8

9 7 5 Euphoria Global Equity Risk Appetite Panic Source: CSFB Whilst we cannot predict the timing of an improvement in risk appetite there it is likely that investors gradually perceive less relative risk in equities given current yield spreads to cash and bonds. Do companies have the capacity to pay or increase dividends? Companies across the Australian and New Zealand market are generally in good shape. Companies reduced leverage following the GFC with aggregate market gearing levels now the lowest in three decades. ASX200 Gearing (Gross Debt to Book Value of Equity) Australian Market Resources Industrials* % New Zealand Market % Industrials exclude LPTs, infrastucture, utilities. Data monthly from Source: RBA, Worldscope, CIRA 9

10 Stronger balance sheets are facilitating a return of capital to shareholders or in combination with payout ratios being slightly below average the ability to increase dividends over time. Australian Market Payout Ratio 120 All Ordinaries Resources Industrials* % % End of "double taxation" of dividends *Market exlcuding resources Source: IRESS, Datastream, Citbank Another area we can examine with companies is their solvency or perceived market risk. A way to measure this is by looking at the spread to Libor for their issued debt. As the below table shows, the perceived risk of many of the larger Australian and New Zealand companies are trading close to that of the perceived safer country debt issues. Whilst this may reflect issues with foreign government finances, it could also indicate that both NZ and Australian governments and corporates are perceived by the market to be more credit worthy. Issuer S&P Rating Spread to Libor (basis points) Australia AAA -78 New Zealand AA -27 USA AA+ 13 Germany AAA 32 France AA+ 127 Japan AA- 128 Westpac AA- 140 Auckland Airport A- 162 Woolworths A- 163 Telecom A- 163 NAB AA- 177 Telstra A 180 Contact Energy BBB 223 *Libor reflects the average interest rate that leading banks charge when lending to other banks. It is commonly used as a finance benchmark around the world. Source: Bloomberg, Harbour. Data as at 14th February

11 Return p.a % How can investors obtain a diversified portfolio of equities that seeks to pay out a regular quarterly income stream? Many individual investors currently generate income from equities by investing directly in a small basket of companies. There are a few issues with this concentrated approach. Some investors may hold investments in five to ten companies spread across a handful of property companies and maybe a bank, telecom company or another utility. Such an approach may have merit, but it can be associated with several risks such as: Too much sector concentration Too much individual stock concentration A buy and hold strategy which does not take into account changing economic, market and competitive forces The potential tax inefficiency relative to a collective vehicle The potential of higher accounting and administrative costs relative to a collective vehicle Exchange rate and reinvestment risk Lumpy dividend flows Liquidity risk To illustrate the risk of holding a five stock portfolio, we have conducted a simulation of 1000 iterations of a random five stock portfolio to highlight this issue with returns relating to actual stock performances over the past 10 years. As the chart below shows the average return outcomes are 11%, however the risk of those portfolios as measured by the standard deviation of returns averages 26%. As a guide the standard deviation of the NZ stock market is around 13% over a 10 yr time period. A pooled investment vehicle targeting a diversified portfolio should be expected to have an even lower risk profile than the market. Monte Carlo Simulation of 5 Stock Portfolio 60% 40% 20% 0% -20% -40% -60% -80% 0% 10% 20% 30% 40% 50% 60% Risk p.a Source: Harbour 11

12 At Harbour, we believe a better approach to investing in equities for income is to invest in a broad portfolio of quality companies via a pooled Portfolio Investment Entity vehicle. This approach may provide better diversification in investment outcomes across the New Zealand and Australian market and less potential stock specific risk. Harbour has developed and launched the Harbour Australasian Equity Income Fund in order to deliver income and potential for capital growth from investing in a range of companies across New Zealand and Australia. The Harbour Australasian Equity Income Fund investment process blends a quantitative screening process with a fundamental analyst overlay in forming the portfolio. This fund is highly diversified across Australia and New Zealand and will hold between stocks. Income distributions will be paid on a quarterly basis and there is no performance fee. IMPORTANT NOTICE AND DISCLAIMER This note is provided for general information purposes only. The information is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of publication and are subject to change without notice. To the extent that any such information, analysis, opinions or views constitute advice, they do not take into account any person s particular financial situation or goals and, accordingly, do not constitute personalised advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any persons. Investment in funds managed by Harbour Asset Management Limited can only be made using the Investment Statement, which should be read carefully before an investment decision is made. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. No person guarantees repayment of any capital or payment of any returns on capital invested in the funds. Actual performance will be affected by fund charges. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this presentation or its contents. 12