Income Report / Income Report: Why shares are becoming the ‘go too’ for income in this ‘mad world’ (AGL, MQGPD, MXT)

**There was an issue with the Income Note being sent as a link this morning, which was done in error. For those who may have missed the email we have included it below**

The market opened lower this morning however selling has now really taken hold, the bounce in the currency back up to above 68c has put the kibosh on stocks. The market was actually looking strong yesterday, particularly with big volume into the close however the opposite is true today. Overall, the market continues to trade in this messy / choppy range where sitting on ones hands has proven the right call. Westpac is leading the banks lower today on further AUSTRAC investigations, currently down ~2% while Aristocrat Leisure (ALL) is having a storming session up ~6% following a strong FY19 result – more on that this afternoon.

We’re taking a slightly different tac on the income note today, looking at returns in this ‘mad world’, outlining why equities are looking attractive for income investors.

Overall, the ASX 200 is currently trading down -69pts or -1.04% to 6743.

ASX 200 Chart

The Income Portfolio was lower on the week off by -0.18% weighed down by Genworth (GMA) which fell 6.22% in net terms, -11.83% in terms of capital offset by a big dividend of +5.61%.. The portfolio is tracking above its benchmarks, currently up +3.90% financial year to date, versus its absolute return benchmark of +1.90%. Since inception the portfolio is up +21.22% vs the benchmark of +12.82%, which is +8.44% in annualised terms.

Why shares are becoming the ‘go too’ for income in this ‘mad world’

With interest rates are record lows, cash offering nothing, bonds likewise, direct property showing low returns for the hassle and liquidity, it’s hard to go past the equity market as a source of income. In today’s note we’ll draw from a recent presentation series we ran at Shaw and Partners titled “Making Sense of a Mad World!”

The first concept to think about is the mad world itself, and it’s hard to argue with it.
1. Lending money to Greece, a country that was essentially bankrupt until an IMF bailout, will pay us 1.49% per annum for the next 10 years
2. Lending money to Germany, a strong country but one growing at a rate barely above inflation will cost us 0.17% per annum for the next 30 years
3. Lending money to the Australian Government will get earn a more respectable 0.72% per annum for 3 years, or 1.13% per annum for 10 years
4. There is more than $US15 trillion worth of debt in the world getting a negative return and interest rates globally are still tipped to go lower
5. Donald Trump has vowed to totally destroy and obliterate the Economy of Turkey ‘if Turkey does anything that I, in my great and unmatched wisdom consider to be off limits’ He has suggested the US Federal Reserve have “no ‘guts,’ no sense, no vision” concluding that the US Central Bank, “don’t have a clue”

At MM we often write about the concept of risk / return, does the return profile that can be achieved look sensible for the risk we’re about to take on? In our view, it’s the bedrock for investment decisions. We spend a lot of time thinking and writing about risks but how should we think about returns, or in other words, what factors should play into our return considerations?

Returns are made up of various components, and each component should command a premium. As investors, we need to ask the question at each stage, are we getting paid for this?

The return components are as follows:

Carry: This is the baseline, or the risk free rate of return. When interest rates were at 10%+, making an adequate return was easy and many investors would not have moved past this point, however when rates are low, we’re forced to go up the risk spectrum. At the current cash rate of 0.75%, we need $10m in the bank to earn $75,000 per annum pre-tax, however the expectation is for rates to be 0.50% early next year, so that number increases

RBA Cash Rate Chart

Term: To get a better return, we can add some ‘term’ to the equation – in other words, locking money up for longer. For instance, a 3 year Government Bond in Australia will pay us 0.72% per annum, by adding 7 years of ‘term’ we get 1.13%, or in other words, we get an extra 0.41% per annum for locking money up for an additional 7 years.

Australian 10 year Bond Yield Chart

Credit: But what about if we take a bit more risk and lend to a corporate, AGL Energy for example, a stable energy provider giving them money for 2 years in a fixed rate senior corporate bond will get us slightly more, something in the order of 2%.

Equity: Or more risky still, instead of lending them our money for a fixed term, are we being paid enough ‘risk premium’ to buy a part of the business with the return being a share in the profits (via dividends) plus / minus any increase or decrease in the overall value of that business. Again, using AGL as the example, the markets best guess for their dividend is 6.07% over the next 12 months with negligible capital gain.

AGL Energy (AGL) Chart

Currency: Australia is a small market and to get exposure to bigger global businesses we need to invest overseas. By making that decision we then have another variable to consider, being currency. If the Australian dollar declines post investment, it’s good, but it’s bad if it rallies. Whatever the outcome it’s adding another variable to the equation and therefore we should be paid a premium for doing so.

Australian Dollar (AUD) Chart

Liquidity: And finally, one of the most important / topical concepts, and one at MM we’re incredibly conscious of is liquidity. Liquidity is the ability to sell an investment when you want to. Property for instance is less liquid than shares, and should attract a liquidity premium. One of the recent trends is ‘alternative investments’, it’s a buzz word and it encompasses things like private equity, however at MM we see a clear risk in securities that provide liquidity (via the ASX for instance) to an illiquid asset class, like private equity.

To sum up, when thinking about returns we should be thinking about Carry + Term + Credit + Equity + Currency + liquidity. It’s about making a determination of what looks attractive based on these considerations, and then going back to simple risk / return metrics.

Investing in this environment

Let’s be frank, there are not many that can live off ‘carry’ while ‘term’ doesn’t add a lot either. Credit does add some return and we find the most compelling ‘credit’ on a risk adjusted basis being in the hybrid space which will yield ~4%.

We currently hold the following hybrids in the MM Income Portfolio: CBAPF, CBAPG, NABPF, MQGPD

We remain comfortable holders of Hybrids – Our No 1 pick based off todays pricing is MQGPD which is trading on a yield to call of ~4.17%


Also in terms of ‘credit’ we hold a diversified exposure to International Bonds via ASX listed NBI & Corporate Loans via MXT. We remain positive on both given current yields of ~4%, however do note that MXT is an example of a liquid security holding fairly illiquid assets.

Metrics Credit Partners (MXT) Chart

Sydney property currently has a gross rental yield of 3.3% before you pay to fix the tap, mow the lawn and pay the agent. This can be juiced up by going to Brisbane which will give you a gross rental return of 4.6%, but that’s before costs and this is unfranked. The other important consideration here is liquidity, property is harder / takes longer to offload than listed investments. Is it just me or is property hard to buy when you want to buy it, and hard to sell when you need to sell it! Liquidity constraints require a premium, however the bullish view from HSBC yesterday for both Sydney (+10%) and Melbourne (+12%) in 2020 paints a more positive picture on a total return basis.

Gross Rental Yields

Source: Core Logic

The forecast yield over the next 12 months on domestic shares is 4% plus franking, however to compare apples with apples, we need to look at the earnings yield. The earnings yield looks at the total earnings a company delivers, not just the amount paid as a dividend.
If the company holds back capital to re-invest then over time, and assuming capital allocation decisions are sound, that should also create value. The earnings yield on Australian shares is currently 6.1%. If we anchor that to the risk free rate, which is the amount we get taking no risk we get what’s called the ‘equity risk premium’. Right now, that equity risk premium is 5.2% which is significantly higher than the 20 year average of 2.7%. A higher number is good, it means we’re getting paid well for taking on ‘equity risk’.

This is the reason why Buffett, Regal and many others are calling equities ‘cheap’.

The other trend worth noting is the consistency of yield from the stock market over the long term – 4% is the norm.

Source: Shaw and Partners

Currency is not relevant for many income conscious investors however liquidity is. The issue with a low rate environment is that there’s a tendency to creep out into other asset classes like alternative assets to get income. While these assets are often appealing given the perception of stability or a lack of volatility, the reason for that stability can often be illiquidity.

To MM, in this type of environment especially, liquidity is a major consideration. If buying illiquid assets, a bigger premium is certainly required.


  • Today’s note was more of a bigger picture diatribe about relative valuations, concluding that equities are cheap in this ‘Mad World’
  • While stocks are cheap relative to bonds, active management remains key in our view

Have a great day!

James & the Market Matters Team


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