Is investing for dividends still your best strategy?

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Last year as the pandemic ravaged the economy, investors expected returns dropped from 8.4% to 5% for 12 months, according to the annual ASX Investor Survey. Retirees were hardest hit, with many reviewing their plans or preparing for a more modest lifestyle.

Investors set about refocusing on portfolio diversity, sustainable income and risk management.

Perhaps the great shock for investors was the erosion of confidence in the two most-utilised mainstream investment opportunities: shares and property. In the sharemarket, more than $6 billion in dividends was cut or deferred last year, much of it from the Big Four banks as they responded to the regulator's request for more capital to be held in reserve against any pandemic triggered financial shocks.

sponsored where to look for income didivends alternative

Investors love affair with dividends rocked

Dividends from the big banks have been a mainstay of portfolio income for many years, but a dividend is not a promise of a given return, and if profits fall, a major purchase is made or unexpected events cause a significant disruption, dividend payouts can be reduced or suspended.

In the first reporting season this year, Australian listed companies paid out nearly $26 billion in dividends, compared to $21.6 billion mid-last year. This is about $1 billion shy of the last pre-pandemic payout level.

More importantly however, the past couple of years have shown us that the reliability we used to expect from dividends no longer exists.

Is property still a worthwhile investment?

Property is another asset that investors have traditionally favoured. While property prices are rising strongly and were up 20.3% in the 12 months to September, the actual percentage rise in September was the lowest in a month since January, indicating price growth is cooling on the $8 trillion residential property market.

The market is also changing, with more first home buyers looking for an investment property as a way to get into the market. Traditional investors are also coming back, following a hiatus as a result of COVID-19.

But while house prices are rising and rents are increasing, rental yields are falling. In the June quarter national gross rental yields were 3.4%, according to CoreLogic. The was down from 3.55% in the June quarter and 3.72% a year earlier. As a rule of thumb, investors typically seek properties with a rental yield above 5.5% as this provides rental income stability.

In May, ABS data showed a 13.3% increase in new financing for investment properties, and that means more housing coming onto the rental market.

So, where to from here?

An often-overlooked asset class in the search for income is bonds. In many cases this stems from a lack of knowledge, and also a bias towards the other asset classes that we know and love.

Think of a bond like a personal loan, only in this case you are the banker. You lend money to a bond issuer and in return they agree to pay you a fixed and regular interest, also known as a coupon payment.

In the risk return spectrum, bonds sit between cash and equity, offering certainty and stability of income, while also providing diversification in portfolios and returns.

Tapping into the certainty of returns

Unlike shares, the interest payments and frequency of payments on bonds are locked into the terms and conditions. They are not reliant on company performance, and compared to shares, less influenced by the boom-bust economic cycle.

Bond issuers are obligated to pay holders their interest, else face defaulting on their obligations.

As an example, when bank shareholders had their dividends deferred in May last year, investors holding bonds in these same banks, continued to receive their payments.

When you consider the large global organisations that issue bonds - Woolworths, Apple, Westpac and Dell to name a few - you certainly would not expect that they would want to be associated with a missed coupon payment or default.

Putting all your eggs in one basket

In addition to the benefits of a reliable income stream, bonds also offer diversification in portfolios, on two levels.

  1. Diversification of returns: Good quality bonds hold their value during periods of market downturn and complement equity portfolios given the inherent lower volatility and correlation to stocks
  2. Diversification via access: Bonds allow holders the ability to diversify across sectors, regions and industries and enable access to companies that otherwise may not be in your reach.

What kinds of returns can I expect?

In the current market, Investment Grade bonds yields range between 2.5% and 3.5% per annum. These are bonds with high credit quality as rated by independent rating agencies such as S&P and Moody's.

They offer a step up in return from cash and term deposits. However, it is important to note that unlike cash in a bank, bonds are not covered by the $250,000 government guarantee on approved deposits, and you are taking on the credit risk of the bond issuer.

If you're willing to go up the risk-reward curve, and take on more credit risk, high yield bonds offer between 4%-6% per annum.

Conclusion

With cash returns at current levels, many investors feel the need to take a big jump up the risk curve to get into equities to seek out additional returns.

While shares do well during periods of euphoria, they do not offer the level of stability, consistency, and reliability of income that you can get from a bond portfolio. Even with market expectations that 10-year yields will rise, which could push down bond prices, if you are after income you can continue to hold the bond, and despite any changes to price, will continue to receive your regular payments and principal investment back at the end of the bond term.

At the end of the day, it is important to diversify your portfolio and not rely on a single asset class to generate your returns.

This information is not advice and has been prepared without taking account of the objectives, situations or needs of any particular individuals. Any individual should consider if the information is appropriate for your own situation. Individuals are advised to obtain independent legal, financial, foreign exchange and taxation advice prior to making financial decisions. Citigroup Pty Limited ABN 88 004 325 080, AFSL and Australian credit licence 238098.

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Nandita D'Souza is the Head of Investment Specialists at Citi Australia. Having lived and worked in Jakarta, Melbourne, New York and Sydney, she brings a global approach to investing and an in-depth understanding of the needs of investors across multiple asset classes. Nandita has a career at Citi spanning over 10 years and holds a Bachelor of Commerce degree with Combined Honours in Finance and Economics from the University of Melbourne. She has a true passion for markets and investments, with expertise across derivatives, foreign exchange and fixed income.