There’s no such thing as a free lunch in investment, but with low interest rates prevailing across much of the stgeloped world, Australian income investors are at least sitting down to a lunch that is relatively well-stocked.
Using the ASX-listed interest-bearing securities market, Australian retail investors can pick up double-digit portfolio yields without taking on too much risk. Even a highly conservative portfolio can easily generate a portfolio yield of 7.5-8 per cent.
“Putting together an interest-bearing portfolio is all about diversification, across different industries, different maturities and different kinds of securities,” says Brad Newcombe, director of listed interest-rate securities and fixed-income research at specialist fixed-interest broker FIIG Securities.
“The basis of your portfolio is going to be very secure, big-bank hybrids and senior debt, and low-risk investments like the Tabcorp Bonds. Conservatively, the big bank hybrids are now trading at 200-250 basis points over bank bills, your low-risk Tabcorp Bonds are similar, so with bank bill rates around 5 per cent it’s not hard to get 7-7.5 per cent.
“The fixed-rate equivalent is a bit higher, at about 7.5-8 per cent. So you can get 7-8 per cent in a conservative portfolio – that should be your starting point.”
Newcombe says retail investors got a bit more choice late in 2010, with the $500 million issue of CBA Bonds by Commonwealth Bank, and the Healthscope Notes, a listed bond, both in November. The Healthscope Notes raised funds to repay the bridge facility from the private equity buyout in 2010 of private health care provider Healthscope.
“Healthscope and CBA are opposite ends of the spectrum – one is a high-risk, leveraged subordinated debt play for a private equity firm, and the other is very secure, big-bank senior debt. It probably would not be wise to put all of your fixed-interest investment into Healthscope Notes, but most portfolios would be justified in having a little bit of it, as long as you have something like a CBA Bonds offsetting it. Putting an interest-bearing portfolio together is all about combining risk-and-return to come up with a portfolio yield that you’re comfortable with: you can afford a bit of higher-risk stuff if you have the lower-risk core,” says Newcombe.
Steven Wright, director of fixed interest at RBS Morgans, says the Healthscope Notes are “clearly at the other end of the spectrum” compared to the CBA Bonds, but considers both as good signs for retail investors heading into 2011.
“CBA Bonds is a senior unsecured floating-rate note, essentially exactly the same as a floating-rate security that an institution would buy, with the only difference being that it is listed instead of trading in the over-the-counter market, and aimed at the retail market.
“In contrast, the Healthscope Notes are a subordinated security. That headline rate of 11.25 per cent clearly captured the attention of investors, but investors need to understand one, the structure of the balance sheet, and two, the fact that they are subordinated to the bank lenders; and they probably need to think whether 11.25 per cent is a fair margin for the nature of the security they’re investing in.
“But I think in 2011 we will probably see some issues that are in-between these ends of the spectrum: I think we’ll see some other bank issues, or other companies, that will give us attractive margins without quite taking us as far to the high-yield end of the spectrum that Healthscope did.”
Wright says the CBA Bonds and Healthscope Notes revived the retail listed fixed-income market after the 2009 issues of securities by AMP and Tabcorp had promised a new dawn. The AMP and Tabcorp issues were considered the closest things to a genuine retail corporate bond that have been listed for a long time: true corporate ‘names’, investment-grade rated, but tradeable in retail volumes.
Although both are five-year issues, there is an important difference: the Tabcorp Bonds are senior debt, whereas the AMP Notes, are subordinated notes, ranking behind AMP’s senior debt.
The Tabcorp Bonds, rated BBB+, were priced at 4.25 per cent above the 90-day bank bill rate, while the AMP Notes, rated A-, were priced at 4.75 per cent above the 90-day bank bill rate.
“I think we’ll see some more issues like CBA Bonds. I think we can look forward to more senior – even subordinated – debt transactions in the retail space,” sys Wright. “Clearly it would be reasonable to assume that all of the banks would have been watching the CBA Bonds issue. It got a good response: they will issue at least $500 million. I think that’s been a pretty good outcome.
The CBA Bonds was offered at a margin of 105 basis points (1.05 per cent) over the 90-day bank bill rate, with a minimum first coupon of 6 per cent. Its initial coupon will be around 6.1-6.15 per cent.
“CBA Bonds was aimed very much at retail investors broadly, which would include self-managed superannuation funds (SMSFs). Really I think it’s giving people an alternative to the hybrids at one end of the scale, and also giving them an alternative to deposits,” says Wright.
“People say, ‘if I’m getting 6 per cent on my deposit, why would I go into this thing?’ but they have to understand that this is going to allow them to lock in current credit spreads for the next five years. Deposits don’t allow them to do that, unless they take a five-year deposit, but then they’ve got no liquidity.”
Investors “would want to lock in these credit spreads,” he says, because three years ago, CBA would have issued this security at only 5 or 10 basis points over bills. “That was because credit spreads were so tight. They’re not quite at record ‘wides’ anymore, but 105 basis points over bank bills is very attractive. Retail investors can lock in that spread now on a floating-rate basis, and still have liquidity, which they have not been able to do before.”
The reason the other banks would be looking at how CBA Bonds has gone is because they “all have similar issues,” says Wright. “One of the markets that has really evaded them is the longer-term term deposits. Despite offering three- and five-year deposit rates, I don’t think it has been particularly successful for the banks in terns of attracting money for those periods: all investors, whether they’re retail or institutional, they don’t want to lock their money up for three or five years without the prospect of having some liquidity. This product provides an attractive compromise, and I’m sure we’ll see similar bank issues – even corporate issues – in 2011.”
Newcombe agrees. “I think corporates will be looking to access the debt markets again after a couple of years of deleveraging. Combined with the announcement in December from the Treasurer that the government is looking at simplifying the retail bond prospectus provisions even further, it makes it potentially quite a bit easier for corporates to issue to the retail market. So I think we’ll see a continuation of issues into the retail interest-bearing market, along the lines of the CBA Bonds and the Healthscope issues.”
Bryan Davies, managing principal of fixed-interest adviser Davies Woods & Partners, says retail investors should focus on the ASX-listed hybrid securities. “Primarily because there’s excellent value there, there is liquidity and – this is incredibly important – you have names that are much more known and followed. If you move into the high-yield space you – corporate bond tranches, for example – in the wholesale market, you typically don’t have any worthwhile coverage in terms of research. For retail investors, there’s nothing outside the listed interest-bearing space on which you can get a decent high-yield return.”
Davies says the listed market offers fixed-income investors a “really terrific bunch of choices,” with very good spreads embedded in them relative to their risks, and going from short-term through to longer-term.
Liquidity is very important, he says, and the better-quality hybrids all have a track record of being able to provide that, with issues turning over up to $6 million-$7 million a day, even more.
“An investor can go from tighter spreads, closer to 200 basis points for some very safe securities, those would have yields of about 8.5 per cent at the moment, through to north of 10 per cent, up to 12 per cent, taking a little bit more risk, a bit more maturity – but still securities that are names that people know and have a bit of research coverage, and have good liquidity.”
Davies says an investor can put together a portfolio of ten or 11 securities where the expected portfolio yield would be somewhere between 11-11.5 per cent. There’s upside on that, he adds, because some of the securities are ‘step-up’ securities, where there is an automatic interest rate increase if the issuer does not redeem the security on a certain date.
“The securities might be redeemed before the step-up date, or not so long after the step-up date: that would really boost your yield. Look at the Dexus RENTS, for example. You’re buying that at the moment at about $90, and it has a step-up date in July 2012. If Dexus redeems that at July 2012 you will pick up the extra $10, so in 18 months’ time, you get a 10 per cent bonus on your money, as well as your running yield along the way.
“Or look at the Orica step-up security, the ORIPB. You’ll pick up a little extra on the Orica, but not nearly as much: people seem to be a lot more convinced that Orica will redeem its security, so there’s only a little 2 per cent bonus on that one. The Dexus one is my star pick, I think they will redeem it, the key consideration there is the cost of funds for them. It probably doesn’t do enough in their capital structure for them to leave it outstanding: if they leave it outstanding initially, I don’t think they will leave it forever. I look at the pricing and what the implicit returns are if they did leave it outstanding forever, and say, ‘that’s not a bad return.’ If they redeem it early the returns are really good,” says Davies.
Davies’ recommended portfolio for a retail investor is shown below, as is a conservative and an aggressive portfolio from RBS Morgans, and a Low-risk and High-risk portfolio from FIIG Securities.
Income-oriented investors should not forget the dividend yields from shares, particularly fully franked shares. For investors on a marginal tax rate higher than 30 per cent, franking credits reduce the tax liability on the dividend. For those on a marginal tax rate of less than 30 per cent, excess imputation credits may be offset against tax payable on other income in the year of receipt, or be claimed as a cash rebate if no other tax is payable.
Investors on the 15 per cent tax rate (for example, a self-managed super fund) actually get a tax refund of $215 for every $1000 of fully franked dividends they receive, because this amount is not needed to offset tax on the dividends. For such investors, a dollar of fully franked dividend income is effectively worth more than a dollar.
Even better is when a SMSF moves to pension phase: in this case, the assets are held in the fund’s ‘pension account,’ which means they are being used solely for the purpose of paying out a pension. In this case there is no tax on the income or capital gains from the assets and the franked dividends can actually be refunded fully by the Australian Taxation Office (ATO).
The following table gives the best expected yields over the next 12 months from shares, according to the analysts at Goldman Sachs & Partners Australia. The yield in the column at far right is that if the shares are held by a SMSF in which all members are being paid a pension.
Share Yields 2011
RBS Morgans Conservative high-yield portfolio*
• equal allocations• Have included a couple of dummy securities that would allow for the types of things that might come to market next year.
Source: RBS Morgans
RBS Morgans Aggressive high-yield portfolio*
* equal allocations
Source: RBS Morgans
Davies, Woods & Partners recommended portfolio:
FIIG Securities recommended portfolios: