Betting on yield

Investment performance in the last few years has been more about interest rate expectations than anything else. As bond yields have moved lower, high yielding stocks have moved higher. The result is expensive valuations on traditional income stocks. Unfortunately historically, higher valuations have led to lower future returns. Investors need to be cautious because once the market starts to price in interest rate rises, the attractiveness of these high yield investments will start to fall.

The high yielding sectors on the Australian market are utilities, financial and telecom sectors. Since interest rates started falling in August 2008, the telecom sector has gained 71%, property 52%, financials 51% and utilities 47%. The only sector that has been these high yielding areas has been healthcare which is up 125% in that time.

Income investing is more than sourcing high dividends. It’s also about finding a sustainable dividend.It’s important to make sure that dividends are sustainable. You can increase the chances of this by looking at a sustainable dividend payout ratio and earnings growth. Dividend payout ratio can help measure the sustainability of dividends. It measures the dividends as a portion of earnings. Generally a payout ratio less than 100% is desirable. Be careful of a payout ratio greater than 100% because it means that the dividend is not sustainable given the conditions which are prevailing at the time.

Also check for growing earnings. Make sure that the company that you are investing is maintaining profit or growing profit so that you can get your dividends. Often if companies get into a rough patch, they will start to cancel or cut back dividends. You want to see forecast earnings growth as at least steady if not positive. Be careful if you see negative earnings growth being forecast as this can be a precursor to dividend payments being reduced or cut altogether.

Central bank induced volatility

The race to devalue has and will continue to have implications for investment returns. The economies which have embarked on quantitative easing have seen some of the best stockmarket returns over the last few years. In the last 5 years to the end of 2014, the US stockmarket gained 85%, Japan stockmarket gained 65% and in comparision, the Australian sharemarket had only gained a measly 11% or 39% including reinvestment of dividends.

Central banks around the world are still moving to cut interest rates. If interest rates get to zero, negative interest rates are no longer out of bounds. There are negative interest rates in Switzerland and Denmark. Both Switzerland and Denmark’s official interest rates currently stand at minus 75 basis points.

Why negative interest rates?

Both Switzerland and Denmark have negative interest rates to stop a flood of money from entering the currency. Switzerland abandoned its defence of the Franc last month and since then, there has been a flood of money to the Krone. In an attempt to weaken the Krone, Denmark’s central bank has moved to negative interest rates. This means that in both countries, customers are charged money to park money in bank accounts. Keep an eye on these developments because what often happens for smaller peripheral countries can often and very quickly move to bigger, more developed economies.

What does this mean for investors?

The truth has been that lower interest rates and the more non-traditional move to quantitatively ease has been good news for equity returns. This means that investors should be keeping an eye and also some money in international stocks. In particular, Europe & Japan should continue to ease. Australian’s can gain exposure to these areas to Exchange Traded Products which are bought and sold on the ASX like shares. IEU is the Ishares Europe ETF. IJP is the Ishares Japan ETF.

The yield trade has been a phenomenal one for investors but is now a crowded idea with most professional and mum and dad investors on the same trade. Be careful and watch interest rate expectations. Once bond yields in Australia start rising, the attractiveness of these investments will decrease.

Essentially equity markets in countries that embark on quantitative easing should outperform with income stocks continuing to gain until interest rate expectations turn.