Investing for an income yield in the current economic environment – which asset class is best?

Welcome to Finance and Fury. In this episode we will be looking at where to invest in the current economic environments for yields, or passive incomes in the current environment.

Best place to invest for yields changes, a lot of this has to do with market environments:

1. Major market changes have to do with a few factors – interest rates, property prices, and dividend policies
2. When looking at the financial markets in general – there are many different places that you can normally get an income – but the fundamentals of these changes with economic conditions – so we will do a deep dive into these and look at what the better places are likely to be to invest over the next few years for a yield return on your money
3. General disclaimer – not intended to be personal advice
4. Before we get into it – have to define what a yield is – it a representation of the income that you receive from your investment – measured as a percentage
   1. All you do is take the income that you get each year and divide this by the value of the investment –
   2. If you invest $1,000 – and get $0 of income from this – your income yield is 0%
   3. If you invest $1,000 and get $50 of income from this – your income yield is 5%
   4. If you invest $1,000 and get $100 of income from this – your income yield is 10%

Now that that is out of the way – Looking back over time at the yields from markets – through breaking this down from asset class to asset class

1. Asset classes – An asset class is a grouping of investments that exhibit similar characteristics and are typically subject to the same market dynamics – easy way to categorise different investments
   1. You can have asset classes like cash, fixed interest or bonds, property or real estate, shares or equities, as well as alternatives like commodities, futures
2. Cash – it wasn’t that long ago that keeping money in the bank account or having a term deposit would yield you 5% p.a. – that is a decent income – when looking at yields in a safe asset – one that doesn’t lose capital value in the short term – 5% p.a. looking back is a pretty good income
   1. But today – 0.35% to 0.70% p.a. depending on the timeframe of a term deposit is the best that people can hope for – most savings accounts don’t pay anything in interest incomes – so cash is not the best place to hold money at the moment if you do need an income – it is still a good place to hold funds if you need funds for expenditures – or emergency reserves – being a few months of total expenses for emergencies- but there are better places to look
3. Fixed interest – newly issues fixed interest and the income that is paid from these assets is highly correlated to the current cash rate (or interest rate)
   1. When government bonds are issued to the market – they tend to pay a coupon yield that is very close to the cash rate – so if you buy a government bond for $100 – you are likely to get
   2. For a corporate bond – you are likely to get a slightly higher coupon rate from the corporate bond – due to a risk premium – risk premium is where you get an additional return due to the additional risk that is carried with the investment
      1. The additional risk here is a default risk – Governments are considered safe from default when compared to a company – so companies typically have higher coupon payments than the cash rates due to this
   3. Either way – the coupon payments on these bonds is correlated to the cash rate – hence at the moment – if you are buying newly issued bonds – your income yield is likely to be low
   4. You could also buy existing bonds that were issued a few years ago when interest rates were higher -bonds have the fixed coupon payments at the time that they are issued to the market
   5. If you were to buy a bond that was issued 10 years ago – you might be getting a coupon payment of 5% -7% – which is a good income based around the face value of that bond
   6. But due to market dynamics – the price of that bond is going to be higher than the face value – to the point that the annual yield on that bond until maturity is going to be very close to the current yield on a bond – for instance – for a bond issued 10 years ago at $100 and paying a $5 coupon payment – which is a 5% yield – today you might be paying $120 for that to the point that where it matures in 5 years’ time – the net yield on holding that investment is likely going to be close to 0.25% p.a. in real terms
   7. So both cash and fixed interest are not providing much of a yield at the moment – looking at the future markets – not likely to be providing one over the next few years either –
4. This has created a situation where people looking for yield need to move up the risk curve – initially – investing in growth assets to look for incomes that aren’t as tied into the interest rate cycle as defensive assets like cash or fixed interest are – there asset classes are traditionally property or the share market
   1. Bit of a side note – most of the alternative asset class markets don’t provide incomes – commodities work off growth returns – so no yields there – like buying gold –
   2. Other alternatives like the futures markets or derivative markets only pay yields if you are the seller of the contract – but I will not be including these – so looking at share and the property market
5. Property market – the yield that you get off property can be categorised in two ways – gross yield and net yields
   1. Gross yield is simple to calculate – you take the annual rental income and divide this by the estimated price of the property
      4. If a property is worth $650,000 and you are getting $550 of rent per week form this – or $28,600 p.a. in rent – this is a gross rental yield of about 4.4% p.a.
   2. The net yield is the income that you receive after all costs – depending on the property type, if agents are used or if there is a loan attached to that property, the net yields can change –
   3. I did say previously that the yields for cash and FI and directly related to the cash rate – it is not exactly true as in a way – property yields are indirectly related to the cash rate –
      1. First – you have the prices of the property itself – as interest rates drop – property prices go up – depending on the measurement – 1% drop in the cash rate translates into an increase on average in property prices growth by 14-17% – based around how much people can borrow due to the affordability of the loan increasing – hence banks will lend more
         1. If prices go up – and rents stay the same – the yield will drop – to illustrate this – if the property is renting at $550 p.w. and the price of the $650k property increases by 17% – the yields drop from 4.4% to about 3.8%
      2. Secondly – you have the take into account the interest costs if a loan is attached to the property – as interest rates drop – the repayments on the property also decline – which increases your net yields

• The two cancel each other out somewhat – but there is still a relationship there

1. Looking at the net yields – you might have agent costs of 8% of the gross rent, rates, water costs, and general maintenance – not to mention body corporate –
   3. Lets say that rates are $2k p.a. and that water is $1k and that general maintenance is $2k p.a. – you have outgoings of about $5k – this would work out to be a net yield on the property of 3.3% p.a. without a loan
   4. If you have a loan – let’s say it is on an interest only loan – at 80% of the value of the property at a 4% interest only investment rate – means there is an outgoing of $20,800 p.a. in interest costs – with no principal repayments – the net yield in this situation is 0.1% p.a. of the total price – however this is about 0.4% of the equity is invested in the property – equity of $130k with a net income of about $512 p.a.

• So it is positively geared – just slightly – but if it was an PI loan at 3.5% for an investor rate – the outgoings each month in repayments would be $2,336 – which results in a net yield of -0.68% p.a.

1. Yields on property have a lot to do with the outgoings as well as the price growth of the property – which for property – is the major consideration as an investment – people should remember that investing in property has more to do with yields than it does to yields –
   1. If the loan is fully paid off – and depending on the property type – like a duel living situation – you can get a decent yield – and when looking at just the equity component – say there is a loan on the property – in the previous example with a 0.1% net yield – this is actually closer to 0.4% p.a. based around the equity of $130,000 in the property when accounting for the loan – but remember if the loan is paid off- the net yield would be about 3.8%
2. Shares – in the current market – shares can pay a higher level of yield – but similar to property – this has to do with what type of shares people are buying
   1. The cash cows of the market – being banks – are currently out of favour – they aren’t paying dividends at their normal rates at the moment due to APRAs requirement that they shore up tier 1 capital –
      1. But that doesn’t mean there aren’t opportunities withing the markets – also – banks are likely to increase their dividends once things within the housing market calms down
   2. Before we go into these – important to point out the differences in the Australian to International Markets –
      1. The Australian market typically pays higher dividends overall when compared to say the US market – or other international markets –
      2. This is looking at the aggregate level of indexes – ASX300 has a yield of around 4-4.5% compared to the US market of about 1.5-1.8% – so the Aus market pays more in dividends overall –

• Important destination has it has to do with the corporate board level of dividend policies – if you are on a board of a company – your sole responsibility should be about shareholder value maximisation – in other words – should you pay shareholders the retained profits of the business or reinvest these within the business? In countries without franking credits – it is often the case that companies decide to reinvest the retained earnings or profits within the business for capital growth – as without franking credits this income gets double taxed – the company pays the tax on the net incomes and then pays out the profits which also get taxed at the individuals marginal tax rate – creates a disincentive for boards to pay more in the way of dividends
  1. Also has something to do with the types of companies that make up the index – large companies in tech that have lots of R&D costs and not much in the way of profits also cannot afford to make large dividend payments – even on the ASX – number 1 company of CSL pays a 1% dividend yield

1. However – if you are a yield hunter – there are better finds within the ASX market due to the higher dividend paying policies as well as franking credits – especially when accounting for the after tax yields
   1. Incomes with franking credits – can have gross and net yields as well
   2. Going back to property for a minute- that net yield – if is it a positive cash flow – will still be taxed – if your net yield is 0.4% on the $130k of equity in the property (but 0.1% yield on the gross value of the property) – that is still a positive income (assuming no depreciation on the property) – so you will pay your marginal tax rate on that yield –
      1. If you are earning $80,000 p.a. – that takes your after tax yield down to 0.25% (at a tax rate of 34.5% p.a.)

• Say you invested that $130k into the share market – or a managed fund or index fund that only invests within equities that pay above a threshold of 5% p.a. in dividends – and say the dividend payment is 5% p.a. being fully franked – The gross dividends would be about $6,500 p.a. plus the franking credits of $2,786 – now both would be assessed as income – total assessable income of $9,286 p.a. – if you are in the 34.5% tax bracket (inc. Medicare levy) – you will pay $3,204 of tax on this – but then get the franking credits back to offset this –

4. Net income – after tax – is $6,082 p.a. – from the gross dividend of $6,500 – which is a net yield after tax of about 4.7% p.a.

1. So when looking for yields – it is hard to pass up fully franked Australian shares – it has been my strategy for a while – to utilise the FF dividends to either reinvest into assets that are undervalued – or to help to build a deposit to buy property

7. Now – the downside to chasing yields through shares – is the additional risks – the volatility – you have to move up the risk curve to chase yields – not too much of a concern if you are younger
   1. This can be a double-edged sword – as technically if the income payments or dividends stay the same – the yields actually go up –
   2. If the dividends remain at the same level but the price of shares goes down – then you can buy more shares at the lower price – long term this can pay off – some of the companies I have purchased over the years have payed dividends (pun intended)
      1. Bought companies back in the GFC – like the banks and TLS – where they were paying about 10-12% yields up until recently – they are more back in line with average market returns of 5% now –that are still paying yields of between 30-50% p.a. based around the prices they were purchased at

In summary –

1. At the moment – looking at each asset class – property or shares are likely to provide better yields due to the cash rate of the economic environment –
2. Then with Property and Share – looking within each asset class – you can get low or negative returns in yields
   1. But overall – Aus Shares due to franking credits can provide the best net after tax yields – but it comes back to the types of shares –
3. However – to get these better yields – have to move up the risk curves which comes with some Downside risks – volatility – can provide an opportunity for additional investments to be made
4. Long term – anything can change – looking at the cash rate – this could rise over the next decade and make cash the better yielding assert – but under the current market environment – low interest rates – cash and FI may not pay much in the way of yield
5. So people are forced to move up the risk curve and assess the investment types that can best achieve their goals

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