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Four ways to secure higher yield at lower risk

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A chart of the official cash rate is among my favourites on the Reserve Bank website. I remember when the cash-rate target was 17% in 1990. Money-market rates had risen more than 7% since early 1988 and the ‘90s would, thankfully, prove to be the high point.

Borrowers were being crushed and savers like me were lapping up high Term Deposit (TD) rates. Fast forward almost 30 years and the official cash rate is 1.25% and the market has priced in another two cuts over 12 months. Some economists tip a 0.5% cash rate.
 

Chart 1: Official Cash Rate

 

For savers, a top bank TD pays 2.6% for 12 months. That will edge lower as interest rates are cut again. With the annual inflation rate at 1.3% in the first quarter of 2019, savers will barely get a positive real return as rates fall. Heaven help savers if we get to a 0.5% cash rate.

At the same time, the longest global equities bull market in history is much closer to the end than the start. The S&P/ASX 200 index is up 18.6% year-to-date (including dividends) in an increasingly expensive market.

I’m not saying equities will correct tomorrow, but as prices climb, savvy investors should ensure they have a “late-cycle” portfolio that is more defensive.

That is what the pros are doing. Global fund managers who are “overweight” cash are at the highest level since the depths of the financial crisis in 2009, according to a Bank of America Merrill Lynch survey. Sure, they missed part of the latest equities rally but will be glad to have more cash to protect their portfolio and buy bargains when markets tumble.

Sourcing reliable yield

Conservative income investors face a conundrum. As share markets rise, they should be gradually reducing equities exposure and adding more cash. But the cash yield is not enough to live on, unless you have several millions tucked away.

It’s no surprise that investors are buying large-cap income stocks as a cash proxy. Think Telstra Corporation, the Commonwealth Bank or even BHP Group for its 5% yield. That’s a lot better than a bank TD and some modest capital growth sweetens the total return.

Anecdotally, some self-managed superannuation trustees (SMSFs) do not care if the share prices of Telstra or CBA rise or fall; they just want fully franked yield and no dividend cuts. They are investing for decades and expect the share price of household-name stocks will rise. For them, it’s mostly about the yield from income shares.

This is a dangerous strategy on several fronts. First, holding a handful of blue-chip stocks for yield exposes the portfolio to equity-market and company risk. Telstra’s grossed-up yield of 9% looks good on paper, yet the total return (including capital growth) over three years is zero.

Buying big miners for yield is risky. Yes, BHP, Rio Tinto and Fortescue Metals Group have magnificent cash-flows, but depend on hard-to-predict commodity prices. Conservative portfolio investors shouldn’t take commodity-price risk for a modest yield.

There are better ways to secure yield at lower risk. The starting point is asset allocation and having a plan to make your portfolio more defensive at this point in the cycle. What is your target allocation for equities, fixed interest, property, infrastructure and cash? And how should that allocation be tilted so that your portfolio has a more defensive structure?

The next step is using managed funds for yield. Why get a 5% yield from a single stock – and take all that company risk– when you can get the same yield (after fees) from a fund that holds dozens of stocks, is professionally managed and provides better risk-adjusted returns?

Here are four strategies to make portfolios more defensive. They suit conservative investors who want to achieve higher yield while preserving portfolio capital.

 

1. Maximise cash returns

It’s remarkable how much “lazy cash” exists in Australia. That is, cash parked in online savings or broker accounts earning almost nothing. Some investors think the cash return makes little difference because rates are minuscule.

Consider a $2-million SMSF with 30% in cash. An extra 1% on that cash is $6,000 of income – or a second holiday each year, for some. When the cash rate is so low, every extra basis point of income makes a difference, so work the portfolio cash allocation as hard as possible.

Cash exchange-traded funds (ETFs) from BetaShares and iShares are useful. They provide cash exposure without locking money away in a bank TD and are bought and sold on ASX like a share. The big advantage is liquidity; the drawback is lower rates than TDs (roughly 50 basis points) and brokerage costs when you buy and sell the ETF.

I prefer bank TDs over cash ETFs for conservative investors who rebalance portfolios annually. If you are in and out of the market faster than that, use a cash ETF.

Blending bank savings products with different maturities is the best strategy. For example, most of your cash in 12-month TD or longer if you can tuck it away, and some cash in an at-call account for emergencies to buy equities when the market corrections arrive.

Stick with TDs from Authorised Deposit-Taking Institutions (ADIs) to get the government guarantee on deposits up to $250,000. Then find the highest-paying TDs.
 

2. Corporate bonds

Several listed income funds have joined ASX in the past few years: the Metric MCP Master Income Trust (MXT:ASX) and Neuberger Berman’s NB Global Corporate Income Trust (NBI:ASX), for example. These and other funds invest in the bonds of listed and unlisted global companies.

NBI is an interesting option. Listed in September 2018, NBI aims to deliver consistent income of 5.25% (after fees), paid monthly. That is derived from a portfolio of 250-300 large, liquid companies worldwide.

NBI invests in the debt of billion-dollar companies such as Netflix, Hertz, Energizer and Goodyear in the US$2.7 trillion corporate-bond market. Some of their bonds yield above 6%.

NBI’s portfolio is mostly stacked with companies with BB and B-rated credit (speculative grade). The investments are spread across sectors and countries, and global high-yield bonds are historically far less volatile than global equities.

The asset class returned 17.6% during the 2008-09 Global Financial Crisis compared to negative 22.6% for global equities, highlighting the defensive qualities of bonds relative to equities.

A 5.25% yield through NBI is no world beater, but in a low-rate context is relatively attractive, given the risk profile. Also, corporate-bond exposure enhances portfolio diversification. Australian retail portfolios are known for being badly underweight bonds.
 

 3. Global infrastructure

Pension funds on average allocate 5% of their portfolio to global infrastructure and some local industry super funds have higher exposure, mostly through unlisted infrastructure assets such as airports, water utilities, seaports, telecommunication towers and information registries.

Chosen well, global infrastructure can provide equity-like returns with lower risk. That’s because core infrastructure often involves regulated monopolies that have inflation-linked revenues. And because the asset has a lower correlation (relationship) with equity markets.

Global infrastructure has performed strongly so far this year and some Australia-run infrastructure funds have delivered cracking returns. Magellan Financial Group, RARE Infrastructure, Macquarie Group and Lazard Asset Management are strong performers in global listed infrastructure over long periods. Altas Infrastructure is another worth watching.

Some ASX-quoted infrastructure ETFs have also had good performance over the past few years, thanks to strong gains in their underlying index. Examples include the Magellan Infrastructure Fund Currency Hedged (MICH:ASX) and Vanguard Global Infrastructure Index ETF (VBLD:ASX).

There is a solid case to add more infrastructure exposure to portfolios – partly for its defensive qualities and partly for the prospect of reliable, solid yield. However, much depends on the interest-rate outlook. Rising rates are bad for interest-rate-sensitive sectors such as infrastructure.

I expect global inflation and interest rates to stay lower for longer as the world battles secular stagnation. Global infrastructure should outperform in that context and has a useful diversifier role in portfolios given its lower correlation with equity-market movements.
 

 4. Equity income funds

ASX has a range of yield-focussed Exchange Traded Funds (ETFs) based on indices designed to enhance dividend. The iShares S&P/ASX Dividend Opportunities ETF (IHD:ASX) is an example. It provides exposure to 50 high-yielding shares and has returned 8% annually over three years.

Low-cost ETFs that are bought and sold on ASX have their place. But I prefer active rather than passive funds at this point in the share market cycle because they have managers who try to limit losses in a downturn. You do not want the ETF or ‘market return’ in a bear market.

In active funds, the Plato Australian Shares Income mFund (PLI01:ASX) is a good choice for conservative long-term investors. It is tailored for investors in the pension phase who can enhance income through franking credits and special dividends.

Available through the ASX’s mFund settlement service, the Plato fund invests in mostly blue-chip Australian shares with higher fully franked income.

The fund has had three-year annualised return of 12%, nearly all of which came from income rather than capital growth. Since inception in 2011, the fund has returned 13.1% annually and delivered 3.6% excess income return compared to its index.

Importantly, the fund has delivered attractive returns with less risk because it is stacked with large-cap yield stocks.

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531). All prices and analysis at June 19, 2019. This material is intended to provide general advice only. It has been prepared without having regarded to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.