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Yield at all costs - A Sideways Look at 'HIGH' Yielding Equities

It’s no secret that term deposit rates are at historically low levels. The average term deposit rate at the moment, be it 1 year or 5 year, is 2.6% p.a.

This has encouraged investors to look elsewhere for yield. Reserve Bank Governor Adrian Orr has been quite active in encouraging investors to take on more risk, not only by slashing the Official Cash Rate, but also through his corresponding commentary.

The swell of funds from within NZ has been complemented by international funds with a yield mandate looking for yield at all cost. These funds have flooded into traditional yield stocks, particularly in the infrastructure, utility, and listed property sectors.

This flood of funds has conspired to push the yields in these sectors down to historical lows. This is of no surprise as yields in the equity market should track underlying interest rates.

There is a concept in finance known as the ‘risk free rate’. This is the rate of return you could expect to enjoy without taking any risk. Broadly speaking, this rate should be approximately the Official Cash Rate (without wanting to get bogged down in too much detail). However, for most investors, the most obvious proxy for a risk free rate is the term deposit rate.

At the time of writing these rates are 2.6% p.a. on average. Traditionally, yield stocks would trade at a premium of 3 to 4 percent above the risk free rate in order to compensate investors for the extra risk they are taking (these are sweeping generalisations, and there are a multitude of other factors at play). As you can see from the table below, the premium that yield investors enjoyed over term deposits has shrunk considerably. This means that investors in some high yielding equities are now accepting a lower risk premium.

The question investors need to ask is whether the smaller premium is appropriate or not. Is the risk of owning Mercury NZ Limited or Goodman Property Trust (the two stocks highlighted in the table above) lower than it has been historically?

Looking around the world at the moment, it is clear that there are still risks that could upend the market at any point. This could be tomorrow, or it could be in ten years’ time. Knowing what will happen is impossible, but preparing for any eventuality is not.

One way to prepare is to ensure you are not part of the crowd buying traditional yield stocks at any cost. Goodman Property Trust is a good example of what can happen in a downturn. During 2008, the zenith of the last financial crisis, Goodman’s share price dropped 34.48%. That is not to say they would fare so poorly in the event of another downturn (their gearing is lower for starters), but investors buying Goodman on the market at the moment are returning only 1% more than what they can get on Term Deposit (3.6% vs. 2.6%). This might be fair if the yield was a forecast to grow, but analysts are picking for it to remain broadly flat. This is likely the reason why analysts who cover the stock value it at $1.68 per share on average (an implied yield of 4.73% p.a.).

A key part of preparing for any eventuality is ignoring Adrian Orr. He wants investors to take more risk across the board. We recommend investors continue to maintain the same asset allocation in spite of the lower yields currently on offer. A disciplined approach to asset allocation is incredibly important for long term returns.

Our model portfolios are below. As you can see, our Investment Committee recommends including fixed interest no matter your risk tolerance. Part of our portfolio management service is ensuring clients do not diverge too far from our target asset allocation. As yields have dropped, it has become tempting to hunt for yield at all costs. This temptation should be avoided.

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