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Yields the new king? - Eureka Report article

October 8, 2008
Yields the new king?
By Scott Francis

PORTFOLIO POINT: One big rate cut, and the possibility of more, take cash rates below yields on shares.

They say that somewhere in the world there is always a bull market - and you would have to think that the bull market right now is for financial commentators. With markets extraordinarily volatile and serious problems in world debt markets passing through to the banking system, it hardly seemed necessary for the Reserve Bank to slash interest rates by 100 basis points to give pundits something to talk about. Yet it has anyway.

It is a gut-wrenching time to be an investor (or a financial adviser, I can assure you), waking up to see, daily market movements on a scale that used to take three months. This week we got more than three months worth of rate cuts in a single announcement.

This makes a subtle change to the investment landscape. With the cash rate down to 6%, suddenly the income paid from investing in shares would appear to be higher than that of the cash rates, (according to ASX Research) a 4.9% cash yield plus 1.5% franking credits (assuming franking at 70%) - a total gross yield of 6.4%.

There is also significant speculation that interest rates will be cut even further, reducing the cash rate and, more than likely, the cash return that investors receive. Listed property trusts (or, as they are known now under a new "Americanised" name REITS, or real estate investment trusts) have an average yield of 8.47%, according to ASX Research.

I say the income would "appear" to be higher for both listed property and overall sharemarket earnings, because there must be some concern over exactly where company earnings and dividends are going to be for 2008-09 - in turn, this affects the "earnings" estimates that give us the current earnings yields the market suggests.

Analyst expectations still seem to be reasonably strong, but with all that is happening in markets at the moment it is hardly surprising that they may take a little longer than usual to update their spreadsheets. A large part of the Australian market is made up of commodities and banks, and it is easy to see how the dramatic fall in commodity prices and difficult banking conditions could impact earnings.

Further, banks and listed property trusts may be tempted to reduce their dividends as part of the process of "recapitalising", or building up their funds; yesterday's remarkably swift move by the giant REIT Stockland to successfully raise $300 million is a strong example.

Rather than paying out as much of their earnings in dividends and distributions, they may keep those funds to assist in paying down debt or purchasing assets.

That said, forecasts for overall economic growth, including from government sources, remain positive. This is a key long-term driver of company earnings growth: if the economy is growing it is likely that corporate profits (in the long term) will continue to grow. The sharp interest rate cut and any others that follow will reduce the interest costs of companies, a positive move for listed companies.

The other immediate impact on individuals will be savings in the order of $2000-3000 a year on the average mortgage. There seems to be much wisdom in the very simple strategy of keeping mortgage repayments at the same level they are now, which means that you are actually paying more off your outstanding loan balance. "Deleveraging", or reducing the level of debt held, is just as important a strategy for individuals as it is for companies in the current environment.

For listed companies, the 100 basis point interest rate cut is important. There are two ways companies can raise money to fund new projects: they can either issue more shares, such as Leighton did recently; or borrow money. With share prices so depressed it is hard for companies to issue more shares to raise money; shareholders (quite rightly) don't want to see large numbers of shares issued at low prices to dilute the shareholdings of everyone. Having said that, powerful institutions such as Commonwealth Bank are ready to move: the bank today announced a $2 billion institutional placement in order to buy BankWest.

The other option available for most companies is to borrow money, something made extremely difficult by the conditions in debt markets. However, the interest rate cut means that those companies that are able to borrow can do it at a better rate.

We live in interesting times, far too interesting for my liking. Through all the volatility it is worth keeping in mind that there are two benefits from investing in growth assets: we expect that they will increase in value over the long term; while providing an ongoing series of dividends. The sharp fall in the value of growth assets means that the income from shares and listed property trusts is now better than you can expect from a cash account, assuming that there is not a sharp drop in dividends and distributions, which has to be acknowledged as a possibility.

Most importantly, everyone now can get funding for less than they had to pay a week ago. It's a universal "positive shock" to the system, with the ASX taking another 5% hit today. Nobody is saying it is the answer but for private investors it means it's time to be thinking about their investment income needs, and the best way to achieve them.