Sleep-Easy Investments

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1 Sleep-easy assets in volatile times PUBLISHED: 12 Jan :32:11 UPDATED: 12 Jan :43:59PUBLISHED: 12 Jan 2013 PRINT EDITION: 12 Jan 2013 Tony Featherstone BetaShares Drew Corbett uses a buy-write strategy to enhance yield. Photo: Rob Homer Technology stocks, commodities and emerging markets are usually the stuff of investment bubbles, not high-yielding blue chip shares. But after strong gains last year, a bubble of sorts is developing for prominent income stocks. Twelve months ago there were some very good yield ideas for share investors, says RBS Morgans adviser Ken Howard. There are not nearly as many defensive yield stocks available now at attractive prices, given the rally over the past year. That does not mean investors should dump their shares in Telstra, banks, utilities or Australian real estate investment trusts (A-REITs). A focus on reliable income stocks rather than growth stocks is still a sound bet, given expectations of a slowing economy this year, persistent global sharemarket volatility and the likelihood that dividends will dominate total shareholder returns. The danger now is in buying income stocks at elevated levels and using their yield as a surrogate for bank term deposit returns, because of the higher volatility of equities and the potential for capital loss. Any investor who thinks they can just jump straight from cash to high-yielding stocks without taking on extra risk is living in false hope, says BetaShares head of portfolio construction Tony Rumble. There s nothing wrong with adding income stocks to the equities component of your portfolio if you think the yields will support higher returns. The problem is when investors use these stocks to produce the same or better yields than cash and aren t aware of the equity risk added to their portfolio.

2 A better strategy for conservative investors is to find investments that provide higher returns than term deposits, and have less risk than holding a handful of shares directly. Such strategies are readily available if you know where to look. Smart Money asked market experts to nominate their best sleep-easy investments strategy for risk-averse investors who are content with single-digit returns. Their ideas ranged from inflation-linked bonds to floating rate corporate bonds and notes, funds that specialise in hybrid securities, exchange-traded funds, listed investment companies, funds that use options strategies to boost income and defensive equity portfolios. Online savings accounts were also recommended for those not quite ready to leave the safety of cash. These sleep-easy investments are particularly useful for investors who sold shares during the global financial crisis, reinvested in term deposits and must now take greater risks to produce decent returns but are concerned about leaping from cash investments into income stocks in a volatile sharemarket. It is not an easy decision. A 1.75 percentage point cut in the official cash rate since October 2011 has helped push the maximum term deposit rate down to 5 per cent (for a year), according to Infochoice.com.au. At the start of last year, investors could get up to 6.1 per cent on a term deposit an attractive return given weakening share and property prices. With financial markets pricing in another quarter to half a percentage point cut in the official cash rate this year possibly up to a full percentage point, on some economists forecasts term deposit rates have further to fall. Earning $40,000 on a $1 million term deposit will seem frightfully low, and those who lock deposits away for three to five years to get a slightly higher rate face the prospect of low returns and potentially higher inflation eroding purchasing power. As the cash rate falls, expect a stronger move into high-yielding blue chips a trend that is already entrenched, with several bank stocks, Telstra, utilities and A-REITs outperforming the sharemarket. Although they were a winning strategy last year, income stocks do not suit all investors. For one thing, valuation risks have risen for the most popular ones. Commonwealth Bank of Australia, for example, has a one-year total shareholder return (including dividends) of 33 per cent. And Telstra has returned a whopping 40 per cent over one year (in dividends and share price growth), and was a great investment for those smart enough to buy near $3 a share. Not surprisingly, most analysts have hold recommendations on both stocks and new investors face the prospect of lower yields if Telstra and CBA shares rise. Telstra s 6.5 per cent forecast yield (9.3 per cent grossed up for franking credits) is only a few percentage points better than some sleep-easy investment ideas on this list. After sharp price gains, Telstra has arguably become less attractive on a risk-reward basis compared with several floating-rate corporate bonds.

3 The same could be said of Commonwealth Bank, considered among the world s dearest bank stocks after stellar price gains last year. Market risk, too, remains high as the United States government grapples with worrisome debt problems and a sluggish economic recovery, the European debt crisis inevitably reignites and China s economy returns to higher growth. In Australia, an expected peak in the mining investment boom and ongoing weakness in other sectors is fuelling expectations of a slow, grinding sharemarket recovery this year. Long-term investors who buy stocks for yield may be less concerned by sharemarket falls and stock price gyrations. But those who need access to their savings, and cannot withstand potential capital losses, can scarcely afford such luxury. Oft-cited comparisons between bank stocks yielding 7 per cent and term deposits returning 5 per cent overlook the volatility in bank shares, which can easily rise or fall 15 per cent in a year and worry investors during sharemarket corrections. Portfolio construction is another challenge. Conservative investors might be better off holding in the core of their portfolio low-cost, diversified index investments that provide the market return and yield, and using active managed equity funds as portfolio satellites to achieve a return greater than the market. Another problem is return expectations. With the 90-day bank bill swap rate at 3.1 per cent, a 7 per cent return in this market, with an appropriate level of risk, seems reasonable. Investors need to readjust their expectations about what is a fair return for the level of risk, says Elizabeth Moran, FIIG Securities director of education and fixed-income research. An 8 per cent to 10 per cent return in this market requires taking on high levels of risk. I doubt conservative investors realise how much risk is involved with higher-yielding securities. Sharebrokers might scoff at a modest single-digit return. Bell Potter Securities adviser John Reynolds, for example, targets an annual return closer to 12 per cent. We aim for good quality blue chip stocks that can provide at least 5 per cent in capital growth and 7 per cent in yield after franking, Reynolds says. Also, some will argue this is no time to buy sleep-easy assets, given the sharemarket s rally in the second half of 2012, and with yields on many blue-chip stocks dwarfing term deposit rates. That said, the following ideas show solid single-digit returns can be achieved with far less risk than picking a handful of popular high-yielding stocks. 1Online savings accounts Commentary on falling cash returns usually focuses on term deposits and overlooks their poor cousin, online savings accounts. Analysis prepared for Smart Money by Infochoice.com.au shows online savings account rates have fallen less than term deposit rates in the past year. In January last year the best six-month term

4 deposit was 6.11 per cent (for six months) from UBank; now the best return is 4.75 per cent from ING Direct. The best online savings account last January was 6 per cent from ANZ (for five months). Now the best is 5.1 per cent from ME Bank (for 12 months, then 3.5 per cent). Average online savings accounts have fallen less in the past year than term deposit rates, simply because banks are still promoting their online accounts pretty hard, says Alastair Schirmer, general manager of Infochoice.com.au. Online savings accounts offer better short-term rates than term deposits, are simpler products and do not require funds to be locked up for months or years. Investors can always negotiate for higher term deposit rates and, if the official cash rate continues to fall this year, returns on cash products will drop further. But for now, a 5.1 per cent return from an online savings account still looks reasonable for highly conservative investors. 2Inflation-linked bonds A 2 per cent inflation rate seems a low concern given myriad other problems facing investors. However, rising healthcare costs are a significant issue for self-funded retirees and a good reason to ensure their portfolios are protected against higher inflation. FIIG s Elizabeth Moran favours inflation-linked bonds which pay interest at the consumer price index rate plus a margin. Moran s top picks are the Sydney Airport and Envestra inflation-linked bonds, which have margins ranging from 4.2 per cent to 4.5 per cent on top of the 2.5 per cent inflation rate (the midpoint of the Reserve Bank of Australia s targeted inflation rate band). These inflation-linked bonds offer excellent returns for investment-grade risk, Moran says. Better still is knowing the yield is hedged against rising inflation, which remains a medium-term risk if interest rates fall to record lows and potentially over-stimulate the economy. 3Floating-rate bonds One of Australia s leading bond and derivative strategists, Mike Saba of Evans & Partners, believes high-grade floating-rate bonds should have a big role in any sleep-easy portfolio. Saba recommends floating-rate over fixed-rate bonds because they have a variable coupon rate, which is linked to a money market reference rate plus a margin. Floating-rate bonds allow conservative investors to take interest-rate sensitivity out of the equation as distributions are not fixed but vary with the rise and fall in the short-term market rate, Saba says. For floating-rate bonds, the payments are locked at a spread over the variable reference rate, this in most cases being the 90-day bank bill rate, which moves closely to the cash rate set by the RBA. In contrast to fixed-rate bonds which can be sensitive to interest rates, the capital price of a floatingrate bond is not greatly affected by rising or falling rates. Buying a fixed-rate bond may not be a sleep-easy investment: if rates rise, the capital price may fall as the fixed coupon becomes uncompetitive.

5 Saba prefers higher-ranking floating-rate bonds such as Commonwealth Bank (CBAHA 4.31 per estimated per cent yield to maturity), ANZ s subordinated note (ANZHA 5.08 per cent yield to maturity), and the Westpac subordinated note (WBCHA 5.04 per cent yield to maturity). He also likes the recently issued APT Pipelines subordinated note (AQHHA 6.7 per cent yield to maturity). Although these yields look modest compared to grossed-up yields on shares, Saba says there is scope for higher returns from contracting credit spreads a solid recent trend. This in turn lifts the securities capital price. An investor who needs to roll over $500,000 from a term deposit could buy four or five bank or corporate floating-rate bonds, knowing they are much higher up in the capital structure than hybrids and that they are buying bonds from high-quality issuers, says Saba. Floating rate bonds are also liquid compared to a term deposit. As always, investors must be comfortable with the issuing company. 4Hybrid funds Much-maligned hybrid securities, which have debt and equity characteristics, have copped a pounding from critics who believe they behave too much like shares, are too complex and have too much uncertainty surrounding conversion of the loan amount into cash or equity. Hybrids are not without risk, and those issued by smaller companies do not qualify as sleep-easy investments. Nevertheless, much of the negative commentary has focused on isolated examples of poorly performed hybrids, overlooked yields of 6 per cent or more from high-quality issuers such as the big banks and neglected to consider the benefits of owning a portfolio of hybrids to spread risk. Elstree Investment Management director Norman Derham believes hybrids are misunderstood. Our analysis shows volatility in hybrid securities was about half that of the equity market during the GFC. Even at the worst point of the GFC, hybrid returns were around 30 per cent better on a rolling 12-month basis than the sharemarket, he says. Effectively, you get an equity-type expected return from hybrids with lower volatility. Derham says investors who use a barbell strategy holding bank term deposits at one end of their portfolios and bank shares at the other should consider bank hybrids instead. You can get a similar type of yield from bank hybrids without the volatility that comes with bank shares. He believes conservative investors should use funds that specialise in hybrids rather than buying them directly, which is sound advice given their complexity. The Elstree Australian Enhanced Income Fund, an ASX-listed investment trust, typically holds 30 to 35 hybrids, with no more than 6 to 7 per cent of the $18 million fund invested in a single hybrid. The fund returned 7.32 per cent (excluding franking) in the year to November 30 and has a solid long-term record. 5Equity income strategies Income-enhancing strategies using options are popular with yield-driven investors. Such strategies aim to make extra income from a share portfolio by buying shares and selling away some of the upside share price potential of the portfolio.

6 This is done by writing call option contracts over an equivalent number of shares to derive extra income in the form of an option payment (a premium) from the option buyer (a buy-write strategy). Understanding the strategy, or using fund managers who employ it, is well worth the effort. Landmark research conducted by the independent financial research body SIRCA and released by ASX this year back-tested returns over several years. The research showed it was possible to generate an additional 3 to 7 per cent return each year, on top of the dividend yield, using a buywrite strategy. BetaShares head of investment strategy Drew Corbett says its new Australian Top 20 Equity Yield Maximiser Fund uses a buy-write strategy to enhance yield. Essentially, the fund aims to generate additional income over and above the grossed-up yield (after franking credits) from the top 20 stocks, he says. Holding a basket of the 20 largest stocks, which are typically more defensive during sharemarket corrections, makes sense for conservative investors. The extra potential yield from the buy-write strategy does not have huge extra risk if one assumes the market is likely to remain flat or make modest gains this year. Buy-write strategies typically work better in markets which are flat or falling rather than strongly rising. 6Listed investment companies The big LICs remain one of the simplest ways for conservative investors to gain diversified equities exposure. The Australian Foundation Investment Company delivered a 31 per cent one-year total shareholder return in 2012, Argo Investments returned 28 per cent and Milton posted 29 per cent. Those returns are unlikely to continue in The three LICs traded at unusually large discounts to their net tangible assets (NTA) a year ago as the LIC sector lost favour. Each now trades at a slight discount or parity to NTA after share price gains in the past year and renewed interest in LICs. Unlike exchange-traded funds, which aim to replicate an index, the big LICs provide moderate active exposure to Australian shares. They are well suited to conservative investors who want exposure to blue-chip shares, reasonable fully franked yield and low ongoing management fees. Although likely to suffer if the sharemarket falls, the largest LICs have good long-term records. 7 Exchange-traded products Several strategy-focused ETPs have been launched in recent years to provide investors with index-like exposure to higher-yielding stocks. They include the Russell High Dividend Australian Shares ETF, Vanguard Australian Shares High Yield ETF, ishares S&P/ASX High Dividend ETF, and the SPDR MSCI Australia Select High Dividend Yield Fund. Like all ETPs, the yield ones are bought and sold like shares on an exchange, have low fees and provide diversified exposure by replicating an index based on dozens of stocks. Differing index methodologies mean the yield ETPs can include quite different stocks. Some have more exposure to mid-cap growth stocks, which might not suit conservative investors. ETPs should appeal to investors who like the idea of gaining yield from a basket of stocks, rather than holding a few income shares directly, and who are willing to take some equity risk if the market falls.

7 8Defensive yield stock portfolios Conservative investors who seek higher returns from shares should consider a portfolio approach rather than buying a few stocks directly. RBS Morgans Ken Howard says income-seeking investors can build a portfolio based on the big four banks, Telstra, Woolworths, Wesfarmers, AGL Energy and Origin Energy. He also favours the new A- REIT, Shopping Centres Australasia Property Group, which counts Woolworths as its tenant. He suggests large property companies such as Stockland, Lend Lease Group and Mirvac Group will appeal later in the year as confidence in housing construction lifts. Howard says investors should focus more on the sustainability of the dividend rather than the headline yield. In this market, you should be willing to sacrifice some yield if it means holding a high-quality company that has greater dividend certainty, he says. Woolworths is a good example; a fully franked yield just above 4 per cent is less than many defensive yield stocks provide. Yet it is one of the country s best-quality companies and has a good long-term record of lifting its dividend. Bell Potter s John Reynolds suggests building an income portfolio around the big four banks, Telstra, Westfield Retail Trust, Sydney Airport, APA Group and AMP. More aggressive investors might consider beaten-up retailers such as JB Hi-Fi and Myer Holdings, which offer 6.4 per cent and 8.4 per cent forecast yields respectively and will benefit from further interest rate cuts. A-REITS have also become more popular with income investors. Listed property trusts substantially outperformed the broader sharemarket last year, with investors attracted to the sector s high yield and willing to forgive its past sins notably excessive debt and risk taking. Although more modest gains are expected this year, a portfolio of high-quality, high-yield A-REITs still appeals. The author owns CBA, SYD, WOW, WRT and AMP shares. He is consulting editor for the ASX Investor Update e-newsletter. The Australian Financial Review