Investing for income in a world of disappearing yields

When we discuss significant developments for investors in the past 5 years, we usually think about volatility. But the really big change is actually the disappearance of yield.

The trend started with government bond yields tumbling; Australia is about the only high quality sovereign for which 10 year bonds yield more than 3%. Bank deposits in major nations yield effectively nothing; even the fabled Australian 6% pa one year term deposit now yields only 4%.

The contraction in yield has now spread to growth assets; rising equity markets have cut the yields available on blue chips in both Australia and overseas. Consider some Australian investor favourites:

Investors in need of income, who stayed out of the market because of their fears, those of their advisors, or those of the “experts” they follow, now face a situation where available yields have fallen sharply on virtually every asset class they might consider. Capital security they may still enjoy, but at the cost of huge drop in income.

For investors in this situation, it demonstrates the potential costs of trying to pick the bottom of the market. Consider December 2011, when some were calling a 20% fall in the market:

– A CBA shareholder who sold in the expectation of that 20% fall, might have been able to buy back into CBA on a yield of ~8% rather than 6.8%. That’s an extra 120bps of yield – a useful pickup if it had occurred, but not earth-shattering.

– But it didn’t play out. A CBA shareholder who sold in December 2011 sacrificed their 6.8% yield, and is now looking at buying back in at a 5.1% yield – some 170bps less than what they were already enjoying.

What’s more important here? Trying to pick the bottom of the market (and the peak of yields) – or avoiding a situation where you miss out on good yields, because you are out of the market waiting for a crash which never comes?

In the case of CBA, 6.8% pa was already a great yield on a great business. For most investors, it’s more important to lock in that sort of yield, than speculate on going for a bit more, and risk ending up with a lot less.

This simple example has wider ramifications for super – in a defined contribution system with no guarantees, what should be the end goal for members?

From this perspective, we see two major member segments in super funds – those who have “enough” to convert their accumulation balance to a useful income stream, and those who don’t:

– Members who don’t have “enough” – broadly those with $100,000 in super assets or less – will cash out of the system in a majority of cases.

– Members who do have “enough” – those with at least $100,000 in super – will convert to an income stream a majority of time.

Members in the second category are in a similar situation to our CBA shareholder above. More than a predictable capital balance, they actually need a predictable, permanent income stream, or as close as you can get to that goal – derived from a portfolio of assets which delivers a steady income stream which grows over time.

Some of the better run SMSFs look to be doing something like this. Interestingly, we are starting to see developments within collective funds along these lines – for example QSuper’s Long Term Accumulation initiative also refers to the idea (in a much more sophisticated way) that a predictable level of retirement income is more important than a predictable capital outcome.