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Equities versus bonds: retirees need to be more cautious than ever

Emma Rapaport  |  28 Jun 2019Text size  Decrease  Increase  |  
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In the lead-up to retirement, there is a widely held view that investors should scale back on stocks in favour of less-risky asset classes like term deposits and fixed income.

But with global cash and bond yields at historic lows, some investors might be concerned about staking their retirement on these defensive assets.

If interest rates are going to be lower for longer, Ausbil fund manager Paul Xiradis posited that conventional wisdom of fixed interest dominating retirement portfolios appears outdated.

Xiradis says retirees could be better placed seeking income from equities with stable earnings growth than bonds, if structural changes to the world's economy are taking hold.

"We find ourselves in an era where technology means far greater productivity, and has improved costs of doing business," he says.

Though it's now 10 years since the GFC, Xiradis suggests the recovery of global growth hasn't been overly strong, and is now faltering slightly – indicated by declining interest rates.

"And I think part of the reason that last year we started to see markets sell off was the view that rates were going to go higher, and recession was around the corner.

"But now the Fed has pivoted and changed its tack to being supportive of growth, which says to me that perhaps the world can't live in a higher interest rate environment. Now this is here for a generation or so, if that's the case."

Figures provided by Morningstar Investment Management show there have been remarkable developments in world bond markets over the quarter. The key move has been the sharp drop in US bond yields: the 10-year Treasury yield is now only 2.08 per cent, down 0.6 per cent since the start of 2019.

Yields in other major markets have also dropped. The yield on the 10-year German government bond, for example has turned negative (currently negative 0.25 per cent), and already negative yields in Japan and Switzerland have become even more so. 

Xiradis believes there could be some correction in long term bond rates, but that rates aren't going north in a hurry.

"The real challenge is for retirees and others which are really requiring income, you're not going to get that from fixed interest investments and deposits, so there is a case for equities."

Xiradis made the comments in the context of reporting on the activity of the Ausbil Active Dividend Income fund (43164) almost one year since its launch. The fund, run by ex-head of Australian Equities at AMP Capital Michael Price, seeks to give investors exposure to a portfolio of Australian listed companies which are "expected to have growing dividend streams supported by revenues, earnings and free cash flow".

Portfolio managers across the board acknowledge that advanced economies globally, including Australia, have struggled to stimulate meaningful inflation increases, particularly wage growth.

"We're not seeing the wage growth that consumers need to go out and spend. That will cause a reflationary impact on inflation measures in many advanced economies," Fidelity's Anthony Doyle said earlier this month.

As rates have dropped, dividend yields have stayed steady, data from Ausbil shows.

Cash rate compared to dividend yield: 20-year to November 2018

dividend yield rba cash rate
Source: Ausbil, RBA

"This differential has become quite significant such that dividend yields currently stand at around 4.4 per cent a year against a cash rate of 1.5 per cent per annum. For comparison, over the last 20 years the average equity dividend yield has been around 4.09 per cent, compared to the average official cash rate of 4.14 per cent," Price says.

If rates stay at record-lows, that could indeed continue to favour equity investors.

Lower yields have boosted the valuation attractiveness of equities, and income-oriented sectors like property and infrastructure have been in particularly high demand, according to Morningstar Investment Management's latest global economic outlook.

It suggests the profit outlook for 2020 looks somewhat better, and that local equities may continue to be supported both by profit growth and further falls in interest rates.

Morningstar Investment Management head of multi asset portfolio management Brad Bugg agrees that interest rates, based on current dynamics, are going to be a lot lower than they've been historically.

"We've obviously had the mining boom pass us by, we've got high levels of household debt in the economy and that means people can't necessarily afford to pay as much, and that just means we think there's going to be lower interest rates," he says.

He says shares are a good place to look for investors sitting in cash as "historic dividend yield for Aussie shares has been in the four to five per cent range".

However, he doesn't think shares are the only answer.

"I think there are other parts of the market which people can look to which they haven't needed to look to in the past.

"Yes, it's true for a lot of government bonds yields are struggling, but I think different parts of the bond markets offer higher yields than traditional term deposits, such as credit, private debt markets," he says.

When it comes to income funds, Bugg acknowledges that they've become very popular with retail investors, and believes the strategies certainly have merit, but warns they can be more sophisticated and contain more risks than investors might suspect.

"Some use option strategies to try and protect the capital, as well as protecting the level of dividend which is being paid," he says.

is an editor for Morningstar.com.au

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