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Franking changes won’t deter stock investors

Nicki Bourlioufas  |  19 Nov 2018Text size  Decrease  Increase  |  
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Various experts believe Australian dividend stocks will remain popular if a Labor government is elected and follows through on its proposed changes to dividend imputation credits.

Morningstar's head of equity research and practitioners within financial planning and funds management – for both equity and fixed income funds – hold this view, even as uncertainty prevails regarding other potential flow-on effects.

The Labor Party has said it will abolish cash refunds for surplus franking credits from 1 July 2019 if it wins government. Under this policy, franking credits would still be claimable as a tax deduction on income, but surplus credits won’t be refunded.

Some pensioners will be exempt from the rule. Individuals and funds currently receive a refund of franking credits if the franking credits they receive on dividends exceed their total tax payable. Those not paying tax, including superannuation funds where members are in pension mode, would be the most advantaged.

storm doom

An investor run on REITs, infrastructure stocks and bonds is one doomsday prediction 

Worst-case scenario

One of the doomsday scenarios expounded by some commentators includes an investor run on other income-producing assets like property trusts, infrastructure stocks and bonds.

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According to Morningstar head of equities research, Peter Warnes, if surplus franking credits are removed, property trusts and infrastructure stocks could experience increased demand from investors, but not necessarily in a big way.

“If the proposal is brought in, then you might see some investors reduce their exposure to shares paying fully franked dividends like the banks. But they are yielding around 7 per cent, so the income is still good, so many investors will keep those shares.

“The income stream from government bonds is safer but the yield is less than half, and bonds need to be held to maturity. Capital losses can be meaningful if bond yields rise,” says Warnes.

“You can’t get 7 per cent on a bond. The 15-year bond yield has still got a 2 in front of it. Then don’t forget that you can lose part of your investment in bonds, unless you hold it until maturity,” he says.

Nor will property trusts or infrastructure stocks offer 7 per cent yields. “Real estate investment trusts and infrastructure stocks won’t be matching that. Moreover, those stocks are riskier than bank stocks as they can have more debt on their balance sheets, so investors must be aware of the increased risk to these stocks should bond yields rise,” says Warnes.

REITs raise risk, says adviser

Scott Keeley, a financial planner with Wakefield Partners, has been discussing with clients the possible change in policy and alternatives to fully franked shares.

“REITs with their consistent distributions are proving an attractive sell to these clients. We’ve needed to be firm on our discussions with these clients regarding appropriate asset allocation, diversification and risk.

“We would regard a number of the smaller REITs as riskier than bank stocks. While they are backed by tangible assets, the debt levels for many of them are a concern," he says. Keeley prefers larger diversified REITs, which minimises risk through multi-property exposure, or one of a number of index-tracking property exchange traded funds.

He believes income-producing Australian shares are still likely to appeal to investors, including those with self-managed super funds. “Most accept that even without the refund of franking credits, Australian shares still provide a significant income for them in retirement, so I do expect that any changes to the make-up of portfolios will be gradual and minimal,” says Keeley.

Bonds may also see increased flows, says FIIG Securities head of education, Elizabeth Moran.

“There is a huge range of risk and return available in bonds. Investors can expect to earn between 2 per cent to 10 per cent per annum on individual bonds, while a low risk,
predominantly investment grade portfolio will earn 1 to 2 per cent more than deposits, throughout the economic cycle.

“Removing the tax incentive on franking credits should encourage investors to rebalance
their portfolios, as current policy distorts the risk and reward assessment, favouring high
risk asset classes," Moran says.

She singles out hybrids as structures that could become considerably less attractive than
subordinated bonds, whose features are far less risky while offering similar returns when
investors cannot claim franking credits.

“If an investor cannot claim franking credits, the return from hybrids would be insufficient, making subordinated bonds a far superior investment,” she says.

What about SMSFs?

Self-funded retirees may be the worst affected by the policy, if introduced, says Plato Investment Management CEO, Dr Don Hamson.

Individuals who narrowly miss out on the aged pension due to the assets test "could stand to lose up to 30 per cent of their current income levels if they solely invest in fully franked dividend paying companies," he wrote in a recent paper Which individuals may be impacted by the ALP franking credit proposal?

“Our modelling also reveals that the maximum dollar and percentage loss of income will be felt by the least well off self-funded retirees with taxable income levels around $30,000 a year for an individual home-owner.

"Franking credit refund losses reduce as taxable income rises, mirroring the rising average (and marginal) tax rate of the Australia personal tax system," the paper says.

“There would, however, be strong incentives for such retirees to spend sufficient money (on for instance holidays or the home) to bring them below the assets test maximum, so as to receive a part pension and full refund of franking credits. This, of course, defeats the purpose of the ALP policy,” Hamson says.


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