As an increasing proportion of the Australian population moves into retirement, income has become an important investment theme. Future returns from traditional sources of income look lacklustre, with the yield on two-year Commonwealth government bonds less than 1% p.a and savings accounts even lower.1 Poor performance of some individual large blue chips has raised questions over the wisdom of holding a small number of local shares for income. These traditional sources of income may no longer be able to provide an adequate and reliable income stream to match investors’ needs.
Time to Rethink Your Income Strategy
With little expectation that the economic environment will change any time soon, income portfolios need to evolve. It’s an opportunity for investors to rethink their return expectations and home biases, be more selective of their investments, and open up to a wider set of opportunities beyond Australia. At the same time, investors should take care to avoid “yield traps”.
We believe sound income portfolios require a combination of strategies, with high yielding equities holding a significant place in the short to medium term as interest rates stay low. However, we also believe that holdings in high yielding equities need to be truly diversified and can be vulnerable to yield traps.
Income Strategy in Equities
While equity income strategies focused on dividends have done well in the past, not all equity income strategies are created equal. A market-capitalised equity strategy such as the S&P®/ASX 200 index has delivered higher income returns to investors than bonds and fixed term deposits over the past decade. But the strategy could be at risk from its concentrated exposures in financial and resources stocks, which have traditionally had the largest weights in the index. The resources sector in particular is vulnerable to changes in the global outlook for economic growth.
Mitigating Yield Traps
Investors who buy companies solely on their historic dividend yield may be exposed to the so-called “yield trap”. This can occur when prior dividends paid by a company prove to be unsustainable and its share price falls. Last year’s dividends combined with a falling price this year can make the historic dividend yield look unrealistically attractive. A strategy that applies systematic checks and balances based on well-defined characteristics could be a potential solution. For example, the MSCI Australia Select High Yield Dividend Index uses the following checks and balances when selecting high yielding equities:
- Dividend persistence. Defined by the five-year dividend-per-share growth; excluding stocks that have seen dividend falls of 5% or more.
- Dividend sustainability. Excluding stocks with zero or negative payout ratios.
- Price performance. Identifies stocks with negative returns over the preceding 12 months and excluding the worst 5%.
- Quality. Measured on metrics including return on equity, debt-to-equity, and variability of earnings; excluding poor quality stocks.
Dividend yields from a selective strategy like this may not be the highest yielding, but they could offer a degree of downside protection because the underlying stocks tend to better endure difficult market and economic environments. For example, high quality stocks have historically outperformed low quality stocks, likely due to the fact that high quality stocks tend to be more financially stable and able to sustain earnings, and thereby dividends.2
Considering Going Global
It is true that dividend yields on global equities have previously lagged Australian stocks and they also do not carry franking credits. However, we believe investors looking for a more diversified equity income portfolio can benefit from global equities. A domestic equity income strategy may hold 30–45 securities, but an international equity income strategy can easily hold around 100 securities without sacrificing yield.