Five great charts to help income investors

Photo of Shane Oliver, AMP By Shane Oliver, AMP

min read

Many alternatives to bank deposits, but know the risks.

The low interest rates of recent times, along with periodic turmoil in investment markets, has provided a reminder of the importance of the income (cash) flow or yield an investment provides. It is particularly important for those relying on investment income to fund living expenses.
As with all investment topics, investing for income can seem complicated and daunting once you move beyond bank deposits, but in fact it’s quite simple. This article looks at five charts I find useful in understanding investing for income or yield.

Chart 1: There are many alternatives to bank deposits

The yield an investment provides is basically its annual cash flow divided by the value of the investment.

  • For bank deposits, the yield is simply the interest rate. For example, one-year term deposit rates in Australia are about 2.25 per cent, so this is the cash flow they will yield in the year ahead.
  • For 10-year Australian Government bonds, annual cash payments on the bonds (coupons) relative to the current price of the bonds provides a yield of 2.8 per cent at present.
  • For corporate debt, it’s a margin above government bond yields and depends on the riskiness of the company, but is currently averaging around 3.6 per cent in Australia.
  • For residential property, the yield is the annual value of rents as a percentage of the value of the property. On average in Australian capital cities it is about 3.9 per cent for apartments and 2.5 per cent for houses. After allowing for costs, net rental yields are about 2 percentage points lower.
  • For unlisted commercial property, yields are around 5.5 per cent. Infrastructure investment averages around 4.5 per cent.
  • For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are running around 4.3 per cent of the value of the shares. Franking credits push this up to around 5.7 per cent.

The chart below shows the yield available on a range of investments now and in December 2009.

Source: Bloomberg, REIA, RBA, JLL, AMP Capital

Key messages: First, there are plenty of alternatives to cash when it comes to yield or income. Second, the yields on these investments will move over time and since the aftermath of the global financial crisis the trend has been down.
Of course, investors need to allow for risk. Bank deposits have close to zero risk but any move to higher-yielding investments does entail taking on risk. More on this later.

Chart 2: The gap between yields on different assets relative to historic norms provides a guide to value

The next chart shows average yields on Australian shares and unlisted commercial property relative to the one-year term deposit rate since 2000.

While yields have fallen, the gap between share and property yields and the bank deposit rate is extreme historically, with neither share or property yields plunging to the degree bank deposit rates have. In fact, the share yield is in its historic range.

All things equal, this suggests commercial property and Australian shares continue to provide better value. The same would apply to unlisted infrastructure.

Source: JLL, Bloomberg, AMP Capital

Key message: Comparing yields provides a guide to relative value and at present shares and unlisted commercial property remain very attractive relative to bank deposits.

Chart 3: Shares can provide stronger growth in income with less volatility than bank deposits

Investing in shares entails the risk of capital loss, but can offer a higher and less volatile income flow over time.

The next chart is a bit heavy but compares initial $100,000 investments in Australian shares and one-year term deposits in December 1979 and the income they have provided over time (before franking credits are allowed for in the case of shares).

Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid roughly $2450 in interest (red bars).

By contrast the $100,000 invested in shares would have grown to $1.12 million (blue line) by the end of 2016, and last year would have paid $51,323 in dividends before franking credits (blue bars).

The point is that dividends tend to grow over time (because profits and hence an investment in shares tends to rise in value) and are relatively stable compared to income from bank deposits, which vary with interest rate settings.

Over the period the worst decline in dividend income from shares was 32 per cent between 2009 and 2011, whereas the income from bank deposits plunged 68 per cent between 1990 and 1994 and by 60 per cent between 2011 and last year. Once franking credits are allowed for, the comparison would become even more favourable towards shares.

Key message: While shares come with the risk of capital loss, a well-diversified portfolio of Australian shares can provide stronger growth in income with less volatility in income than bank term deposits.
Investors focused on income need to decide what is most important: stability in the value of their investment or a higher, more sustainable income flow. The key when investing in shares for income is to have a well-diversified portfolio. Better still, a well-diversified portfolio of shares paying high and sustainable dividend yields.
Finding high dividend yields is easy but the key is to look for stocks that have a reliable track record of growing those dividends and have dividends that are not threatened by things like excessive gearing.

Chart 4: A bird in the hand is worth two in the bush

A high and sustainable starting-point yield provides some security during volatile times. Since 1900, dividends (prior to allowing for franking credits) have provided just over half of the 11.8 per cent average annual return from Australian shares and, as can be seen in the next chart, their contribution has been stable in contrast to the capital value of shares.

Source: Global Financial Data, Bloomberg, AMP Capital

Dividends are relatively smooth over time because most companies hate having to cut them, as they know it annoys shareholders.

Key message: A high and sustainable income yield from an investment provides some security during volatile times. It’s a bit like a down payment on future returns.

Chart 5: Yield provides a guide to future returns

The yield an investment provides forms the building block for its total return, which is essentially determined by the following: Total return = yield + capital growth.

As a general principle, the higher the yield an investor invests at, the higher the return their investment will likely provide. This is self-evident in the case of bank deposits because the yield is the return (assuming the bank does not default on its deposits).

It can be seen in relation to bonds in the next chart, which shows a scatter plot of Australian 10-year bond yields since 1950 (along the horizontal axis) against subsequent 10-year bond returns based on the Composite All Maturities Bond Index (vertical axis).

Over the short term, bond prices can move up and down and so influence short-term returns, but over the medium term the main driver of the return a bond investor will get is what bond yields were when they invested.

If the yield on a 10-year bond is 5 per cent, if you hold the bond to maturity your return will be 5 per cent. Of course, a portfolio of bonds will reflect a range of maturities and so the relationship is not perfect. But it can be seen in the next chart that the higher the starting-point bond yield, the higher the subsequent return.

Source: Global Financial Data, Bloomberg, AMP Capital

Put simply, when bond yields are high they drive high bond returns over the medium term and vice versa. For example, when Australian 10-year bond yields in January 1982 were 15.2 per cent it was not surprising that returns from bonds over the subsequent 10 years were 15.4 per cent per annum.

Similarly, when bond yields were just 3.1 per cent in January 1950, it was no surprise that returns from bonds over the next 10 years were 3.1 per cent. At 2.8 per cent now, we are off the bottom of the chart, meaning record low bond returns for the next decade.

Similar, although less perfect, relationships exist for other asset classes – the higher the yield, the higher the subsequent return.

Of course, there are risks investors must watch out for. At the individual share level, a very high dividend yield may be a sign of a "value trap" – where current profits and dividends may be fine but there is an impending threat to the company and so the share price is low.

Second, high distributions may also be unsustainable if they are being paid for out of debt and reflect excessive gearing or high-risk investments (for example, sub-prime mortgages before the GFC). Remember, there is no free lunch.

Key message: While returns have been solid lately, low investment yields do warn of lower returns ahead, most notably from government bonds.

About the author

Shane Oliver is Head of Investment Strategy and Chief Economist at AMP.

Follow on Twitter: @ShaneOliverAMP

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