Building an Income Portfolio: Time for a New Approach?

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1 Building an Income Portfolio: Time for a New Approach? With market volatility and low interest rates set to persist for some time, investors may have to rethink their income strategy to adapt to this new investment reality. Traditional income sources may no longer be able to meet their income needs, while seeking higher returns could lead them into yield traps. Creating an income portfolio that meets the demand of the times presents a daunting challenge for investors and their financial advisers. We offer ideas for portfolio construction across equities, bonds, and sector and factor exposures. Chasing Income In a Low-Rate, Volatile World As Australian life expectancy extends longer than ever, income has become increasingly central for investors and advisers alike. Returns from traditional sources have been lacklustre, as the average one-year bank term deposit rate in Australia is at a 34-year low at 2.35% p.a. 1 and yield on two-year Commonwealth government bonds stands at just above inflation. 2 Investors may find that these asset classes are no longer able to provide an adequate income stream to match their needs. On the equity front, while Australian equity income strategies have outperformed bonds from an income perspective over the last four years (Figure 1), recent poor corporate performance of some large blue chips, primarily resource companies, has raised questions over the sustainability of Australian dividend yields (see page four). Figure 1: Dividend Yield Outperforms Bond Yield in Australia Yield (%) At a Glance The lower for longer environment means investors need to reassess their income strategy to meet their needs ket volatility may push investors into high risk, potentially placing their capital at greater risk (yield traps) Opportunities exist in global equities and bonds for a more diversified portfolio Bloomberg Ausbond Composite YTM S&P/ASX 2 Forward Yield 21 Jun 213 S&P/ASX 2 T12m Yield Source: S&P, Bloomberg Finance L.P.as of Past performance is not a reliable 216

2 What Now for Income Portfolios? 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 underlying investments, and open up to a wider set of opportunities beyond Australia and beyond the traditionally preferred strategies that have worked well in the past. At the same time, care should be taken to avoid yield traps or investments that promise higher returns but place their capital at risk. What Today s Income Portfolio Could Look Like In this challenging environment, we believe an income portfolio would require a combination of strategies depending on the investor s time horizon and risk profile, with investments in high yielding equities holding a significant place in the portfolio in the short to medium term as rates stay low. We also believe that targeted selection of underlying investments plays an important role in building a truly diversified equity income portfolio and in mitigating yield traps. This could mean changing the way investors view opportunities in global equities. Equities While equity income strategies focused on dividends have done well in the past, not all equity income strategies are created equal. Investors and advisers may want to ask themselves the following questions: Are we just trying to increase the level of current income or are we also attempting to lower the volatility of our equity portfolio and/or increase its quality? Are we comfortable accepting the style bias present in most high dividend strategies or will we require offsetting investments? A market-cap-based equity income strategy such as the S&P/ASX2 index has delivered higher income returns to investors than bonds and fixed term deposits over the past decade. However, the strategy could be at risk from the market s inherent concentration towards financial and resources stocks, which have traditionally had the largest weights in the index. Given the poor outlook in the resources sector in the short-term, investors could potentially experience a drag in income returns from a significant decline in those companies dividends. In addition, investors may be exposed to companies in the index that may have unsustainable returns (yield trap). Mitigating Yield Traps As an alternative, investors could consider a strategy that applies a systematic selection of stocks based on well-defined characteristics. An example of this screening process is the criteria used by MSCI Australia Select High Yield Dividend Index, 3 which seeks stocks with: Figure 2: Performance of High Yield Equities in Australia S&P ASX 2 Index Growth of $ MSCI Australia Select High Dividend Index Growth of $ Apr 213 Apr 213 Source: S&P, MSCI, as of Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the Dividend persistence. Defined by the five-year dividendper-share growth; excludes stocks that have seen dividend falls of 5% or more. Dividend sustainability. Excludes stocks with zero or negative payout ratios. Price performance. Identifies stocks with negative returns over the preceding 12 months, and excludes the worst 5%. Quality. Measured on metrics including return on equity, debt-to-equity, and variability of earnings; excludes poor quality stocks Moreover the strategy avoids concentration risk by limiting individual security weights to a maximum of 1% per security. As seen in Figure 2, the MSCI Australia Select High Yield Dividend Index s performance is comparable to the S&P/ASX 2 in terms of income returns and total returns. Figure 3 further shows the performance of stocks with a high quality score using the MSCI filter versus low quality stocks over the State Street Global Advisors 2

3 past 12 months. One explanation for the outperformance is simply that high quality stocks tend to be more financially stable and able to sustain dividend returns. Screening for quality potentially removes more volatile stocks and reduces the risk of investing in yield traps. Dividend yields from a selective strategy may not necessarily be the highest, but they could offer a degree of downside protection because the underlying stocks tend to better endure difficult markets and economic environments. Global Equities Although global equities have previously lagged Australian stocks in terms of dividend yield and do not carry franking credits, we believe investors looking for a more diversified equity income portfolio can benefit from global equities. Whereas a domestic-focused equity income strategy typically invests in 3 45 securities, an international equity income strategy typically invests in around 1 securities, including potentially high dividend yielding stocks in healthcare and utilities, which are relatively under-represented in Australia. A high dividend yield global equity strategy (S&P High Yield Dividend Aristocrats Index) that screens for characteristics such as dividend payout ratio and indicated yield, a 1-year track record of increasing or stable dividends, and liquidity has outperformed a broad-market index (S&P Global Broad ket Index) both in terms of income and total returns over the last 15 years. (Figure 4) Previously available only to institutional investors, targeted equity income strategies are now more widely available through cost-effective exchange traded funds (ETFs). Figure 3: Performance of High Quality vs. Low Quality Stocks % Stocks with Quality Scores >1 Stocks with Quality Scores <-1 Source: FactSet, as of 1 June 216. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the Figure 4: Performance of Global High Yield (with Currency Effect) MSCI World ex-australia index (AUD) Growth of $ Bonds For investors with lower risk tolerance, a bond strategy may remain central to their income portfolio. While rates still remain at historic lows, the Reserve Bank appears to be close to the bottom of the current rate cycle, which bodes well for long-term investors. As with the equity market, the Australian bond market also suffers from concentration risk, with issuances dominated by government-issued bonds. Global bonds offer a wider universe of opportunities, and, given a supportive macroeconomic backdrop, selective exposures in attractive sectors, structures and issuers can provide investors with a stable income return and some level of capital preservation. However, global bond yields (as measured by the Barclays Global Aggregate) have halved since the GFC and are now at similar levels to global dividend yield (as measured by the broad MSCI World ex Australia) see Figure 5. As the Fed begins to tighten monetary policy, bond investors will inevitably feel the pain in the shorter-term. But over the very long term, higher levels of interest rates will be beneficial to bond investors S&P Global Dividend Aritocrats Index (AUD) Growth of $ Source: S&P, MSCI, as of Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the State Street Global Advisors 3

4 As Resources Fade, REITS Shine BHP s dividend cut in early 216 signalled a changing outlook for resource companies as an income play. Resources companies have been the drivers of increasing overall dividend payout ratios in the ASX2 in recent years (Figure 6). We believe that dividends in the sector will be less sustainable in the short term because of poor earnings outlook. Similarly, Australian banks have continued to maintain a high level of dividend payout ratios which is now beginning to place the issue of dividend sustainability under question. The dominance of banks and resource companies in Australia sometimes overshadows the relative performance of other sectors in the market. While banks and resource sectors have underperformed in 215, REITS (real estate investment trusts) have held up well. In recent years, many REIT and A-REIT managers have changed the way they operate and reduced their leverage. This has, in turn, improved their ability to continue paying out dividends. Companies in this space represent high-yield income opportunities for investors. Global listed property also offers strong potential, opening up a broader range of more than 2 companies, from the 25 3 Australian listed property companies. Figure 6: Performance Divergence: Australia High Yield Equity ket Growth of $ Apr 215 S&P/ASX 3 A REIT S&P/ASX 3 S&P/ASX 2 Banks S&P/ASX 3 Materials Source: FactSet, S&P, as of Aug Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the 216 Figure 7: Performance SPDR S&P/ASX2 Listed Property Fund (ASX Ticker: SLF) Figure 5: S&P/ASX2 Payout Ratio % Industrials Banks Resources 213 Source: Bloomberg Finance L.P., S&P, Deutsche Bank, IBES, Datastream, as of 17 June 216. f'cast 217 Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.forecasted payout ratios are based upon estimates and reflect subjective judgements and assumptions. These results do no reflect the effect of unforseen economic and market factors on decision making. The forecasted returns are not necessarily indicative of future performance, which could differ substantially. Past performance is not a reliable Performance Total Return Fund (%) Index (%) 3 Month Month Year Year Year Since Inception (28 ruary 22) Source: State Street Global Advisors (SSGA), as at Past performance is no guarantee of future results. Performance returns are calculated in Australian Dollars and periods of less than one year are not annualised. Returns do not reflect the brokerage fees or the bid/ask spread that investors pay to buy and sell ETF securities on the Australian Securities Exchange. Investment return and principal value will fluctuate, so you may have a gain or loss when units are sold. Current performance may be higher or lower than that quoted. Performance returns have been calculated based on changes in the daily net asset value of the funds (rather than the last quoted price) and are shown net of fees. Currently no Distribution Reinvestment Program is in place for the SPDR S&P/ASX Listed Property Fund. Total Returns reflect combined capital and income performance and assumes immediate reinvestment of distributions. It is provided only for comparison purposes to the S&P/ ASX 2 A-REIT Accumulation Index. The SPDR S&P/ASX Listed Property Fund distributes quarterly. State Street Global Advisors 4

5 Figure 8: Global Bond Yields at Similar Levels to Dividend Yields % Barclays Global Aggregate (USD) T12m Yield MSCI World Ex Australia NR Local T12m Yield Source: Barclays, FactSet, MSCI, as of Jun 213 Past performance is not a reliable 216 Maximising Your Income Potential In a lower for longer environment coupled with market volatility, investors search for maximum income must be balanced against potential risks. In the short-to-medium term, high yield equity may continue to provide a superior source of income compared to bonds. However, to mitigate yield traps, we think investors could consider taking a more focused approach, choosing quality stocks with sustainable yield rather than chasing high dividend yields. Investors may also consider diversifying their core bond portfolios by including global bond investments that are able to benefit from a significantly larger global opportunity set. As a pioneer in ETFs, SPDR ETFs offer a comprehensive suite of low cost global and Australian bonds and equity exposures, including sector and multi-factor exposures, for your income portfolio. Contact our SPDR ETF team or visit sprdrs.com.au. 1 Source: Reserve Bank of Australia, as of Source: Reserve Bank of Australia, as of Yield on two-year Commonwealth government bonds was 1.64% p.a. as of , while inflation stood at 1.3% as of 31 ch Index used by the SPDR MSCI Australia Select High Dividend Yield Fund (SYI). State Street Global Advisors 5

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