The following video transcript may have been edited for clarity in written form.
HL: Hello, I'm Hans Lee from Livewire Markets. And welcome to the signal or noise income investing special. Livewire kicks off its annual income series this week. And so to celebrate, we're kicking off with a cross asset view of the best places to find income in this crazy market. Let's bring in the panel we've assembled for this show.
Aaron Binsted on the far end, the core portfolio manager of the Australian equity strategy, Lazard Asset Management. Happy to have Peter Robinson as well, head of investment strategy of Challenger Investment Management. And of course, it's not signal or noise without her. Diana Mousina, of course, deputy chief economist at AMP and our series regular. Warm welcome to you all. Thank you for joining us.
It's awesome.
Let me start with an opening hypothetical, if I may. If you had to only invest in one asset for income for the next 12 months, what would it be and why? Diana, I'll start with you.
DM: I'm going to say government bonds. And the reason for that is because they do provide a good source of income now, given that yields have gone up so much. And when you look at the other asset classes, the risk around income growth is quite high. If you're thinking about equities for income, there's a big chance that dividend yields will be cut. Earnings will go down. So I think it looks like a more risky place to invest. If I'm just thinking about income and not capital growth, I'm going to go with bonds.
HL: OK, government bonds for Diana. What about you, Aaron?
AB: So I'm obviously the equity guy on the panel. But for a 12 month horizon, I'm going to say term deposits. I think equity is for the long run. But 12 months is just too short of a horizon. So I'm going to ring up Westpac and ask what they can do for me.
HL: OK. Well, you ring up Westpac and tell us what happens afterwards. What would you say, Pete?
PR: So I think the key word here is income. If I'm looking for income, I'm looking at the high yield credit markets, both public and private. I think there's listed trusts listed on the ASX that are trading at fairly material discounts to their tangible assets as well. And so you're looking at yields in the high single digits or low teens. And I think to me, that's adequate compensation for default risks. So I get that capital stability still, but very healthy levels of excess return over what we're generating on cash at the moment.
HL: All right, three very different interesting responses from the panel to kick us off. Well, of course, the most obvious place, I think, that most people think about when it comes to income is dividends and equity. So we'll start with that. Now of course, one of the reasons income is back in vogue as a concept, as an investing style is because of the big surge in interest rates.
And while the big rise in rates has not been so good for some sectors, it has been a big beneficiary to the big four banks. Let's put up this table to consider the following. Year on year, cash profits and operating incomes for the big four are up by 16% and 13% respectively. But the average dividend payout ratio has actually declined slightly. And net interest margins are up 13 basis points in an environment of heightened competition.
So all of that needs to be considered. And all of that actually before we tackle the question of bad and doubtful debts in light of the fixed rate rollout that is occurring this quarter and next. So my question to the panel. Is this a signal that the bank's best days are over? Or is the debate around bad and doubtful debts just noise? Aaron, signal or noise.
AB: So if you look at it in a long-term basis, banks have been in a structural decline in profitability terms since about 2015. So just sector ROEs, excuse me, in that period started about 15%. And they're down around 10% now. So we had some really significant regulatory and capital changes early on. And now, we're getting competitive changes.
And our banks still have higher ROEs than a lot of the OECD competitors. And you'd probably say, there's a fair chance that, that profitability is structurally under pressure. So my view would be, there's much better places to get equities from income than the banks right now.
HL: OK, so you would say, it's a signal that if the bank's best days are over, this is it. It's a signal. Go look somewhere else.
AB: Better opportunities elsewhere.
OK, all right. That's interesting to hear from Aaron. But the average half yearly dividend yield of the big three banks that have just reported, just gone, is 6.25%. What do you think, signal or noise?
PR: Yeah, look, I think there is a lot of rates leverage within the bank business model. So we've had significant hikes in because of the strong deposit franchises that the banks have, as well as the leverage off their capital base. They are a beneficiary of that higher interest rate environment. But I do think that the fundamental risks that reside on the bank's balance sheet make this more of a signal than noise, I think.
If you look at from a fundamental standpoint, the intense pressure we've had on mortgage pricing. We've had the RBA in the 12 months to 31 March increased interest rates by 3.5%. Mortgage rates have only gone up by 2.9%. We've got the term funding facility rolling off. That's going to have to be replaced with government bonds for liquidity purposes. And also have to be replaced with either term deposits or issuance into the debt to capital markets, which is much more expensive for the banks.
Add to this, the focus, I think, that's going to come on the bank's deposit pricing. And I haven't even mentioned bad debts yet. So I think there's a lot of headwinds that are facing the banks in the months and years to come.
HL: Yeah, OK. So I take it as a signal. So you've got a signal there. We've got two signals so far. Diana, we're going to go three for three. Signal or noise.
DM: Yes, three for three, I'm going to agree with the rest of the panelists. Usually, when we have a higher interest rate environment, I think a lot of people assume that banks benefit from that because they can pass on rate rises to their customers. However, in this current environment, as the other panelists have said, with very high competition between the other banks, margins will come under pressure. I think that the banks are signaling that the end of those mortgage wars is coming soon because they can't afford to keep on being competitive on price levels.
At the same time, we have an environment in Australia, where home lending is still under a lot of pressure. I know that house prices are going up. But that doesn't mean that lending volumes are going to follow suit. Lending volume growth is still negative only a year ago. Housing construction numbers are down 20% or 25% compared to a year ago. So from a lending point of view, there's going to be a big loss for revenue for the banks. So I'm going to go with signal.
HL: All right, we got three. We've got three signals, which, I think, is very, very interesting. Aaron, based on what you were saying earlier about just around the headwinds. So if you're trying to look beyond the banks, trying to look for some sectors and stocks that can provide good dividends, better income than the banks over the next 12 months, what would you nominate?
AB: So look, the first start point, I'd say, is insurers. And I think the reason to compare them is they're obviously another beneficiary from higher interest rates. We talked about how that can help banks through their net interest margins. We like playing that with the insurers much, much more for two reasons. One, the primary driver for the insurers is really the premium cycle. Premium growth has been really, really strong. And you know that all else equal, profits will follow premium growth.
And secondly, they do also participate in higher running yields on their bonds. So they do capture that attractive aspect in the earnings. And perhaps, even the better comparison with the banks is they don't have that balance sheet risk. Particularly, our two domestic short tail insurers. If the economy does tip over and does have recession, you don't have that huge risk of earning downside and dividend cuts. So I'd say insurers.
And another one, we lack some more, what we call, defensive consumer names. So one I'd throw out as an example is Collins Foods. So it's the KFC franchisor in Australia. The largest also in the Netherlands. We know that those businesses are quite robust in difficult times. We've seen those US QSR formats perform really well at times like in the GFC.
They also have a margin recovery story going on. Hit by cogs inflation last year, crunch margins. They're coming out of that now both through pricing and as cogs come down. So really strong leverage to the top line. And we think that bodes well for the future.
HL: Yeah, interesting. Collins Foods. Talking about insurers just really quickly, are you talking about NIB, talking about Medibank?
AB: So to be more specific. So Suncorp, IAG, and QBE. QBE is a little bit dynamic to the second tool, the domestic ones. But they have really strong premium growth. And so we like all of those.
HL: OK, interesting. Well, let's move into a different kind of income now. And that is, of course, the bond market, which had a very difficult 2022. And while government bond prices have rebounded nicely so far, there is some action also taking place in another part of the fixed income universe. Let's throw up this chart. This is the S&P 500 investment grade corporate bond index. And it's fairly flat actually so far this year.
But if you look at the company level, we're seeing US tech giants Meta and Apple between them recently selling something like $14 billion worth of long-term corporate bonds. And both companies have promised yields that are 100 basis points, at least above what you would get on a government bond. And of course, retail investors can gain access to corporate bonds through funds or ETFs. So are the Meta and Apple sales a signal that investors are finally taking advantage of the opportunities in fixed income? Pete, what do you think, signal or noise?
PR: I think in Australia, it's nice. Our bond market is really underdeveloped, particularly on the corporate side. So if you just look at listed markets just to give you some context. So in Australia, we've got about $15 billion worth of listed fixed income funds. That's about 1.5% of the total amount of equity funds that are listed. And that goes ETFs, as well as exchange-traded funds.
In the US, that number is about 25% So I think those sales in the US are reflective of what's going on in the US. In Australia, we really have a system that's dominated by the banks. So 75% of non-financial corporate lending flows through the banks. In the US, it's 30%. So unfortunately, I just don't see that as a sign-- these bond sales as a sign that anything is changing in Australia any time soon.
HL: Yeah, interesting. All right, so it's a noise for you, Pete. Diana, obviously, we've referred to this already. But I'd have a hunch you'd look more at government bonds, maybe, per se than corporate bonds. But those yields have roared back to life as well. What do you think, signal or noise?
DM: Well, maybe, for some of those names, it could be a signal for those big cap tech-related industries. And we've seen that in the equity market too over the past month that all this hype about AI and the potential for some of those traditional tech names like Meta, Amazon, Apple to participate in the AI space. Could lead to better prospects for them, especially after they had such a shocking year last year. So maybe for some particular names. But it's a signal, but not for all bonds.
HL: OK, so we'll say signal, but specific. And pretty specific to only some big names. All right, understood. Aaron, I know you cover equities. But it's pretty hard to argue with a local 10-year bond paying a near risk free yield, something around 3.6%, 3.7%. But what do you think, signal or noise?
AB: Yeah, so I reckon we all need to be really careful not to anchor to the 2010s. They were a really, really odd period. Disinflation, perpetual QE, that was an odd period. Yields were unusually low. If you look at Australia in the first decade of the 2000, the government yield was about 6%. In the 1990s, it was even higher.
Now, I don't know if we're going back there, but it's plausible. And I think you've got to be really careful not to anchor just to this weird decade we've come out of. I think you also just want to be careful of inflation. We're still pumping out numbers in the 6s in Australia. If that goes for a while, it's eating your capital every day. And then last, obviously, we do have the potential of credit risk. We know that there are cyclical risks. You just want to make sure that you're not taking equity risk for a debt return.
HL: Yeah, OK. So you'd say then that it's a signal that investors are making taking more interest. Or it's noise and that we're coming out of a weird time.
AB: I'd say it's a signal that we're coming out of a weird time.
HL: OK, it's a signal we're coming out of a weird time. Never have we mentioned weird so much on the same topic on this program. Pete, for retail investors who've never been in the bond market before and to Aaron's point, I mean, we've just come out of a very unusual 15 year period compared to the rest of market history, how would you advise people who've never considered bonds, fixed income in general before? How would you advise them to go about understanding the different kinds of opportunities available?
PR: Yeah, I mean it is-- to overuse the word that we're using, it's a weird time. For much of the 2010s, dividend yield was income. And government bonds didn't provide any income. And because rates kept rallying, you got capital gains. So we are moving back towards a more normalized world. And so what investors can expect from this part of their portfolio is income.
So fixed income, as the name implies, provides income. It can provide capital stability and capital preservation during times of uncertainty. It can provide an equity market hedge as well, which is important. And it can provide liquidity to your portfolio. So it's something that's generally readily convertible for cash.
So I think it's important that investors understand that. It's also important they understand what the yield is. And they're able to break it down into its subcomponents. So the return for cash, the return for lending money longer or the term premium, the credit spread premium, as we've talked about, that 100 basis point excess return for the Meta bonds, as well as the illiquidity premium, or that extra return you get for going into the private or less-traded parts of the market.
HL: So you're talking there about cash there Pete. For our third topic, we're going to move even further down the risk curve to term deposits. Now, over the last 15 years, investors have become used to the phrase coined by Ray Dalio, cash is trash. But over the last year, soaring interest rates have also meant term deposit rates are going up. Meaning cash is no longer trash.
I mean, there are now numerous institutions, including Macquarie Group that are offering well over 4% for a six-month term deposit. And Judo bank's one year term deposit is actually now fetching 4.8% interest. And even Ray Dalio himself turned on cash a few months ago, arguing the following. Quote, "Cash used to be trashy. Cash is pretty attractive now. It's attractive in relation to bonds. It's actually attractive in relation to stocks."
So here's the question for the panel. Is a 5% term deposit, which incidentally would be the highest national average since 2012, is that a signal to invest simpler? Diana, signal or noise.
DM: Well, for the short term, it is probably a signal. Because as we've been speaking about, that's a pretty good source of income for a short period of time. But of course, it depends on your investment horizon. If you're worried about recession risks in the near term as well, then it's another benefit for you. Because while bonds may do OK in a recessionary-like environment, equities will obviously have major downturns. So I'm going to take it as a signal.
HL: OK, take it as a signal. Aaron, based on what you said at the beginning of this program, I think I know the answer. But I'll let you say it anyway.
AB: So I think absolutely signal. And while you don't want to have a permanent large cash allocation for the reasons we've discussed, I think, now, cash is a great diversifier. Markets are pretty fully valued. And we have cyclical risk. Just to give you some context for how we're seeing it. For our Defensive Australian Equity strategy, which is meant to grow in real dollars of income with minimal drawdown and volatility is about 25% cash now. So absolutely, we think it has a role to play at points in time, but not as a large permanent allocation.
HL: So we've had two signals so far from Diana and Aaron. Pete, where are you going to sit on this, signal or noise?
PR: So I'm actually going to sit on the other side. I'm going to say noise. I think, firstly, we have to acknowledge that term deposits are not cash. You're locking up your money for term. You don't have access to that. And so you're giving up optionality and flexibility in the way that you invest. And I think that's really important in the current environment.
And obviously, if you're investing above that deposit guarantee, there's credit risk associated with the term deposit as well. I think, there's better opportunities for income available in the bond market. I think, if you look at that the Judo example, that's about 100 basis points over the cash rate. Judo bond's price in the market about 200 basis points over the cash rate. And they just priced a tier two deal at 500 basis points over the cash rate.
So I think there's better alternatives available than term deposits. And even if we look over history, historically, term deposits would really price around 150 basis points over cash. Now, at 100 basis points over cash. And for the margins well inside of 100, I think that pricing is still pretty tight.
HL: Yeah, OK. Diana, we couldn't do an income investing show without mentioning the other asset class, where you can gain income as an investor. And that's property. I mean, unit rental yields nationally are something in the order of about 4.5%. And we've seen recent data. We saw building approvals recently. The monthly inflation indicator, rent is up something like 6%. How long can that realistically continue?
DM: Well, I think Australia has big problems with housing supply, which is leading to very high rents. So it looks like rental yields can still remain quite high for a while, which is good news for investors. But at the same time, I think that there is still this risk of further falls in capital values. It depends, if you're looking at residential and non-residential. I mean, residential has less downside now. We think that prices will be flat for the rest of this year.
But in saying that, with the Reserve Bank now, price probably to go, again, maybe two more times. Maybe, the property market will have another leg down. But rental yields, I think, will still remain pretty strong. Because housing supply is a big problem. We're not building enough homes.
We've got about 450,000 new migrants coming into Australia. And the building approvals data suggests that we're going to build less than 150,000 homes. So we need to be building closer to 225,000 or 250,000 new homes a year just to keep up with the new demand from migration. So it's a big problem
HL: Yeah, absolutely. Thank you, everybody. It is now time for the charts to watch segment, where we ask each panelist to bring in one chart that investors should take a look at in at least their opinion. I suspect all of these are going to have an income bend. Diana, your chart is one-- I would politely say it's one for the equity bulls, maybe. Share dividend yields versus bank deposits, can you walk us through this one?
DM: Yeah, so I mean, obviously, I did talk about the risks to lower earnings and to dividends being cut. But if you're more of a long-term investor and you do want some income exposure from equities, I think that as an Australian investor, we can get the franking credits. The dividend payoff still looks very attractive from an income point of view.
So if you are an Australian investor, which most of the audience probably is, then it does still look like an attractive place to invest. Just be mindful that there could be large capital losses, if we get that recession or an earnings downturn. Which I think is a big probability.
HL: Yeah, OK. So Diana did a dividend yield chart. And we're also talking dividends for your shot. But actually, you've done yours with a bit of a rate of change perspective. So talk us through this one.
AB: Sure, so this is just the absolute dollars of dividends. The ASX 200 is paid between 2015 and 2019. And there's really two things I think are relevant about this chart. Firstly, if you want long-term income growth, look at equities. Look at the ASX. That's only a four year period. The longer you go out, the better that aggregate income picture looks.
The other thing to call out is that there are different parts of the market that give you dividend growth at different times. From 2015 to 2017, you didn't want to be in miners. Your dividend went backwards quite a lot. But then if you missed that in the next subsequent two years, that was the vast majority of growth for the overall market in terms of income.
And even if you look at that chart, you can see that banks across both of those periods. The two 2-year periods, dividends were up. But actually, dividends per share were flat to down for the banks.
HL: Yeah, that green bar for metals and mining is just insane. And I wonder how much of that is down to BHP, Rio, and Fortescue, and then everybody else as well. So it's pretty amazing. Thank you both. Pete, we were just talking with Aaron there, actually, about property and rental yields as a form of income. You've given us a property-inspired chart. So maybe, walk us through this one and what it says about income.
PR: Yeah, so this chart shows two things. And I think one of which has been talked about a lot. The other, which has been talked about far less. So it's about the fixed rate mortgage cliff. And this chart really shows for CBA, the growth in fixed rate mortgages rolling off. And shows how early we are in that process.
The other thing that it shows that I think is really interesting is the rates that people were on. The RBA cash rate that people were on when they fixed the mortgage. And the new RBA cash rate when they're coming off the fixed. And so if we look backwards, if we look 12 months ago, they were really not experiencing much rate shock.
So there were-- yes, we've had fixed rate mortgages roll off. And it has been benign to date. But they've been rolling off without as much rate shock, as we've got looking forward. So the bulk of the mortgage is rolling off, as we look forward are going from a cash rate of 0.1% to a cash rate of 3.85%. And as Diana said, potentially, higher than that. We've got one more rate hike price. And potentially, more if we keep seeing this strong inflation data coming through.
So I think that those future resets for those fixed rate mortgages are going to be significant. That's why for me, the most important thing is patience. It's going to take time to see these impacts flow through the wider economy. And I like this chart because it reminds me of the importance of staying patient, as we see this cliff pass through.
HL: Yeah, it's a fantastic chart. Listen, that's it. We're done. That's it for signal or noise. A big thank you to Aaron Binsted of Lazard, to Pete Robinson of Challenger, and of course, Diana Mousina of AMP. Thank you very much. Don't forget to check out the rest of Livewire's income series. It starts this week.
We've got a lot of fantastic one-on-one interviews. We've got an income edition of buy or sell, an income edition of the rules of investing. And all of that coming to the Livewire and market index websites very soon. So make sure you subscribe so you don't miss out. We'll see you in a month.
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