The effects, impacts and dislocations of the COVID-19 pandemic have been felt very heavily in the investment markets, and the fluttering of the black swan’s wings has certainly disconcerted income-oriented investors.
The Australian addiction to dividends
As interest rates ground lower in the 2010s in the wake of the global financial crisis, typical income strategies based on bonds became harder to justify. Income-seeking investors were effectively forced up the risk curve, toward corporate bonds, high-yield bonds, cash-generating real asset investments, and the share market.
In particular, the income aspect of share dividends – turbo-charged by Australia’s dividend imputation system – became a major attraction, with effective yields in the 6%–8% range readily available. For this, investors had to accept several facts: one, that the dividends cannot be considered certain until they are paid; two, that dividends are paid at the company’s discretion, and can be cut at any time – even abandoned; and three, that they bore the capital risk of the share market.
Finding yield in new areas
In 2020, as COVID-19 became a fact of life, all three of these facts have forcibly reasserted themselves; particularly the capital risk. The danger in holding ANZ Bank, for example, for the dividend yield, might have seemed largely dormant – until it was halved in price inside a month.
“As interest rates have come down over the past decade, we've had to change the way that we look at income; it's become quite driven by growth assets,” says Angela Ashton, founder and director of managed account provider Evergreen Consultants.
“Having the central part of a portfolio with respect to income production in growth assets like property or shares introduces a lot more risk, unfortunately for clients, but that's the way you need to generate income today,” says Ashton.
While some of the “traditional buckets” that have produced income in the past are under pressure, Ashton says there are opportunities in areas such as diversified credit, some of the Australian REITs, some of the Australian and US ETF equity-income products, and high-quality Australian shares - particularly consumer staples names such as Woolworths, healthcare stocks and infrastructure stocks.
Seeking a new growth story
Jamie Nemtsas, director at independent financial advisory firm Wattle Partners, expects income-conscious investors to take a more ‘total-return-oriented’ approach going forward.
“High income is generally more risky, and ‘sustainable growth’ looks less so at the moment, if you think in terms of total return. You might be looking at a regional building company in New South Wales that has got a strong dividend, on paper; but it’s going to be far better to hold something like Google that has got a massive audience, low cost of capital, great balance sheet, and you're sacrificing some kind of regular income for a very, very strong company.”
In this strategy, Nemtsas says, the investor is looking to “harvest” capital gains, and put them back into an income-producing bucket. “A growth story like CSL, you can sell portions of that holding, for years, and keep putting it into cash. Then you have another stock – it might be Amcor –that is trading sideways, price-wise – but it’s generating income.”
Rebalancing and portfolio management
It simply comes back to rebalancing, he says. “Say you have 5% cash, 10% fixed-income, 30% Australian equities, 20% global equities, and 35% real assets. If you rebalance regularly, and your Australian equities has moved to 34%, you ‘harvest’ that 4%, and put it back to cash. Your capital gain is constantly being converted into your ‘core’ capital, which we like to have sitting there as effectively three years’ worth of cash needs.”
Nemtsas agrees that areas such as consumer staples, healthcare stocks and infrastructure stocks – and what he calls “fallen angel” sectors like travel – offer good opportunities at present. “There are also some great opportunities in credit, particularly in the ‘distressed credit’ space.
“We’re looking at a range of individual investments, some stocks, some ETFs, particularly where we think they’ve been oversold, to set up portfolios for the next few years,” he says. “We’re getting the opportunity at the moment to build portfolios totally differently than we were eight weeks ago. But we’ll stick to that rebalancing strategy – sell those that go up, keep those that go sideways while yielding income. And think in terms of total return, not in terms of maximising your income return,” he says.