The Reserve Bank’s late interest-rate cut, and the prospect of more cuts in the next 12 months, will compound the challenge for income-seeking investors. An official cash rate of 2-2.5 per cent, from 2.75 per cent, will make life even tougher for those living off cash investments.
Falling interest rates will also maintain demand for blue-chip stocks that have high, fully franked dividends, such as the Commonwealth Bank and Telstra Corporate, which are overvalued after stellar gains in the past 12 months. Finding reasonably priced yield stocks in this market is hard work.
Of course, share investors should never buy stocks for yield alone. What good is a 6 per cent dividend if the stock falls by 20 per cent and investors are forced to crystallise losses? Nor should income stocks be viewed as a surrogate for cash or other fixed-interest products, as seems the case these days.
Moreover, as share prices rise, dividend yields are being compressed. Telstra, for example, has a forecast 5.8 per cent yield and Price Earnings (PE) of 16 for 2013-14, according to consensus analyst forecasts. Three of four analysts have sells on Telstra, and one a hold, Morningstar data shows.
In 2011-12, Telstra yielded an average 8.6 per cent and traded on a 11.3 PE ratio. A similar comparison could be made for Commonwealth Bank and other income stocks, which have become less attractive on valuations grounds after strong share price gains, yet could rise further as interest-rate cuts stimulate demand for yield stocks.
This scenario has made exchange-traded products that specialise in yield more attractive. Simply put, ETPs are listed funds that aim to replicate the price and yield performance of an underlying index, are bought and sold like shares on an exchange, and are much cheaper than unlisted managed funds.
ASX-listed ETPs had a combined market capitalisation of $7.2 billion, in March 2013, up 32.8 per cent on a year earlier, ASX data shows. The number of ETPs has leapt from 73 to 91.
But much of the growth in ETP market capitalisation has come from the rising sharemarket. Net inflows into ETPs in April were $85 million and total market capitalisation growth was $281 million, according to Betashares analysis.
That said, the ETP market should grow much faster in coming years as more investors, especially Self-Managed Super Funds (SMSF), embrace low-cost index products, and as continued growth in the number and variety of ETPs stimulates greater demand from investors and interest from advisers.
BetaShares said most fund inflow into ETPs in April was for Australian equity income and high-dividend ETPs. More investors are using ETPs to enhance yield, improve diversification and reduce overall portfolio costs. These ETPs make sense for conservative income-seekers.
Owning an ETP that replicates exposure to dozens of income stocks, and gives significantly higher diversification, is arguably a better strategy that chasing overvalued income stocks higher. Yield-focused ETPs work well in the core of a portfolio, providing low-cost, index-like returns and income.
There are four yield-focused ETPs to choose: the iShares S&P/ASX High Dividend ETP (IHD), the SPDR MSCI Australia Select High Dividend Yield Fund (SYI), the Vanguard Australia Shares High Yield ETF, and the Russell High Dividend Australian Shares ETF (RDV). The BetaShares Australia Top 20 Yield Maximiser Fund (YMAX) uses option strategies to enhance yield, and is a clever twist on yield ETPs.
Russell’s yield ETP had the highest distribution yield at 5.14 per cent at March 2013, followed by iShares (4.54 per cent), Vanguard (4.51 per cent) and the SPDR yield ETP (4.04 per cent), ASX data shows. Dividends from the Russell ETP were 77 per cent franked, giving at 12-month trailing grossed-up dividend yield of 6.42 per cent, according to Russell.
Grossed-up yields from these ETPs are competitive with many popular blue-chip income stocks. The Commonwealth Bank, for example, has a trailing 4.6 per cent yield, or 6.6 per cent grossed-up dividend yield after accounting for fully franked dividends.
The advantage of yield ETPs is higher diversification. The Russell High Dividend Australian Shares ETP, on which its ETP is based, had 51 holdings at March 2013. Investors concerned about rising valuation risks for income stocks should consider taking a “basket” or index approach via ETPs.
Vanguard offers the cheapest yield ETP at 25 basis points annually, and it had the highest one-year total shareholder return at 28.06 per cent at March 2013. It looks the pick of the yield ETPs.
Always consider the index on which an ETP is based and the methodology behind its construction. Yield ETPs have subtle, important differences, with some holding more mid-cap stocks that pay higher dividends and enhance growth, but potentially lift volatility.
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Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.