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The best income-generating assets for your portfolio

The return of cash as an income yielding asset has transformed the investment landscape. For so long the ugly duckling, cash now provides serious competition for every other asset. Stocks, bonds, hybrids, and other assets all need to justify why investors should pay a premium for them versus the safety of cash. That’s especially the case for investors searching for steady income.

Let’s look at the pros and cons of different assets for those seeking regular income, from the lowest yielding to those offering better yields.

Bank savings/money market funds

Bank savings accounts don’t yield much, especially at the major banks. Outside of that, it gets better but often with lots of strings attached.

An alternative is ‘cash’ ETFs. These ETFs can get you a higher yield and good liquidity. The main choices are as follows:

AAA is the market leader and offers the best liquidity and tightest spreads. It’s become a popular place to leave cash with better rates than bank saving deposits. However, it’s also the most expensive on fees, making the others more attractive if money can be left in cash for a while. ISEC carries more risk than the others as it can hold up to 20% in floating rate notes.

Term deposits

Investors have been pouring money into term deposits and for good reason. They’re an attractive option for many investors seeking income. The good news is that banks have improved their offers to attract more depositors. Even the major banks have upped their game after badly lagging for the past 18 months:

  • Commonwealth Bank has a ‘special offer’ term deposit of 5.05% per annum (p.a.) for personal and SMSF customers for 12-23 months.
  • ANZ offers a 5.05% p.a. term deposit for 12-24 months.
  • Westpac has done a little better, now offering 5.10% p.a. over 12-23 months.
  • NAB is at 5% p.a. for a 12-month term deposit.

As is often the case, there are better deals outside the major banks. Macquarie had been aggressive in attracting term deposits though that seems to have recently changed. It now offers a 5.05% p.a. term deposit, largely in line with the big banks.

ING has one of the highest term deposit rates at 5.3% p.a. for 12 months. Judo Bank isn’t far behind at 5.25% p.a. over the same period.

A curious development is that many of the banks which were the most aggressive with their term deposit rates had previously attached many conditions to their offers. I’m thinking especially of ING and Macquarie. However, most of those conditions now seem to have been dropped.

It pays to know the particulars of the banks’ term deposit offers. Here are a few suggestions:

  • There are different rates for term deposits paid at maturity and those paid monthly. Know the difference and what suits your needs best.
  • Know the penalties for withdrawing money from a term deposit early - they vary significantly.
  • Always read the terms and conditions carefully. There may be other ‘nasties’ in there. I read in ING’s terms that it can change the terms and conditions whenever it likes. That’s not nasty, and it might be standard practice, though it’s good to know who’s holding the whip hand in the relationship from the start!

In my own case, I bank with two of the majors though recently chose to open several Judo Bank term deposits, from 3 to 12 months. I found the process both quick and easy.

The big positive for investing in term deposits is that you lock in an attractive yield. The downside is that every term deposit still trails the current inflation rate of 5.4%. So, you’re losing money in real terms.

That may not remain the case if inflation continues to fall yet it remains a risk. And that’s where potential alternatives for getting better yield come into play.

Bonds

Bonds have had a miserable three years, though don’t let that put you off (it’s probably bullish).

10-year government bonds are regarded as ‘risk-free’ as the government will always pay you back. In Australia, these risk-free bonds are yielding 4.48%. That’s reasonable, though down from the peak of 4.98% at the end of October. Many bond funds with a mix of federal and state government bonds offer yields of more than 5%.

Investment-grade corporate bonds have even more appealing yields, anywhere between 5.75% and 6.5%. Note that corporate bonds are riskier than government bonds given their exposure to corporate balance sheets.

ETFs with high quality government and corporate bonds can be a good option. Two of the most popular are Vanguard’s Australian Fixed Interest Index ETF (ASX:VAF) and iShares Core Composite Bond ETF (ASX:IAF). They’re yielding 4.95% and 5.91% respectively.

There are different types of bonds that offer even better yields. For instance, Australian commercial mortgage and private debt have yields of 10-12%. These are potentially compelling as they offer the prospect for equity-like returns with less risk.

Even further up the risk spectrum, there are insurance-linked bonds with yields of up to 15%. These bonds are based on insurance payouts from weather events, and therefore are highly risky and suit sophisticated investors.

With bonds and all assets, the higher the potential rewards, the greater the risks. And vice versa. The trick as an investor is to find the reward versus risk that meets your return expectations and risk profile.

A key benefit of owning government-related bonds is that if an economic slowdown happens in future, bond yields are likely to fall and prices to rise. That way, an investor can get both income and capital appreciation from owning bonds. That’s something that you can’t get with cash.

The greatest risk from owning bonds is inflation. High inflation means rising rates, and bond prices move inversely to rates. It’s noteworthy that 10-year government bond yields are well below inflation at present, which means these bonds are losing money in real terms.

Stocks

For a pick-up in yield, stocks are an obvious option. The ASX 200 is trading at more than 17x trailing price -to-earnings or an earnings yield of 5.81%. On the face of it, that’s not great value compared to the yields of risk-free bonds or term deposits. You’re not being paid enough to compensate for the risks of holding stocks.

The dividend yield on the ASX 200 is 4.44% or a grossed up 6.34%. That’s reasonable, without being outstanding.

As for individual stocks, the banks are a place to start for yield. Yes, they aren’t growing much and may struggle to grow in future. Yet, they are a quasi-oligopoly that should generate adequate returns on capital. Dividend yields on the major banks range from 4.35% at CBA (ASX:CBA) to 6.4% at ANZ (ASX:ANZ) with NAB (ASX:NAB) and Westpac (ASX:WBC) falling in between. These are net yields, and on a gross basis, they look very good.

Outside of the banks among large caps, commodity stocks offer nice dividends though their sustainability and consistency are always the question mark.

Of the top 25 stocks, Transurban (ASX:TCL) looks interesting, with a dividend yield of 4.47%. The stock is far from cheap, though the yield is attractive.


Source: Morningstar

Coles (ASX: COL) is another one that seems reasonable from an income viewpoint. The stock sports a dividend yield of 4.32%. Coles has some headwinds, especially with its inability to execute as well as Woolworth. Though in my experience, ascendancy among the supermarket duopoly tends to ebb and flow over time. The critical point is that the duopoly needs to stay intact and if that happens, then returns and dividends should be ok.


Source: Morningstar

Dividend ETFs

Of course, the other option is to buy a dividend ETF instead of individual stocks. Here are the main dividend ETFs listed on the ASX:

Vanguard’s VHY is by far the most popular dividend ETF, followed by State Street’s SYI.

It’s important to note that each of these ETFs use a different methodology to come up with their underlying holdings.

One potential drawback of these ETFs is that none of them offer fully franked dividends. The level of the franking depends on the franking offered by their underlying portfolio companies.

More broadly, it’s worth mentioning that dividends rely on earnings, and in an ideal world, you want a growing stream of earnings that can pay a growing stream of dividends. It’s not only about the starting dividend yield of an ETF or stock, but what that yield may look like in future.

Also, one potential issue for investors is that stocks and dividend ETFs are unlikely to deliver regular, consistent dividends. The reason is that when there’s a sharp fall in earnings, there’s normally a corresponding fall in dividends.

That said, grossed up yields of 7-9% for solid, growing stocks are worth investigating given their superiority to the yields offered from government bonds and cash.

Listed investment companies

Listed investment companies (LICs) are a popular alternative for ASX dividends. One advantage that LICs can build up cash reserves to pay consistent dividends through an economic cycle. For instance, several of the blue-chip LICs were able to continue to pay steady dividends through the pandemic despite falls to their net asset values (NAVs).

A disadvantage of LICs is that the prices of many seem stuck at perpetual discounts to NAVs. Investors have soured on the structures and fees of LICs, and NAV discounts have proven difficult to remove.

That said, there are a handful of solid, long-lasting LICs that offer the prospect of steady, growing dividends. Australian Foundation Investment Company (ASX:AFI) and Argo Investments (ASX:ARG) are standouts in this regard. Whitefield Investments (ASX: WHF) is smaller yet has a good track record.

Washington H. Soul Pattinson (ASX:SOL) is sometimes referred to as an LIC but it isn’t. It’s a family-run investment company with a long history of outperforming the ASX and delivering strong dividends.

Hybrids

Bank hybrid notes – combining features of both equity and debt - have been hugely popular among investors in recent years. With major banks offering 6-8% yields, and smaller banks more, it’s little wonder they’ve been well received.

I have been, and remain, more cautious on hybrids for a few reasons. The first is the APRA review into hybrids. This might change the ballgame. It’s likely that APRA will change the product terms to make it clear to banks and investors that in times of financial distress, distributions may be missed and AT1 will be converted into equity, or even written off. In other words, APRA will probably want to make it clear that distributions aren’t safe at all costs.

The second reason is that bank hybrids are relatively new products in Australia, and they haven’t been tested across an economic cycle, especially during a serious economic downturn.

Other assets and issues

For the sake of brevity, I’ve only covered the major assets in this article. I also haven’t addressed tax issues with the different assets, or the specific income needs of SMSFs and retirees. That’s for another article.

 

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au

 

42 Comments
Josh
April 23, 2024

What do people make of my portfolio choice?:

AFI 15%
ARG 15%
WHF 15%
SOL 15%

IVV 40%

Terry Brown
November 27, 2023

For two and a half years I have invested spare cash with Balmain Private for terms of 6 months to 18 months LVRs are no more than 60% and interest is paid monthly. They are like a defacto term deposit without, obviously , a guarantee of a return of your funds. I spread my investments with them and my net return is 9% PA. I am very comfortable with this form of investment. I believe the risk is minimal and the company claims that no investor has lost money. They are not for everybody. I also have cash with Ubank and Mystate which offer 5% PA with only minimal conditions to receive the higher rate of interest

Warren Bird
November 28, 2023

No they're NOT (like a term deposit). That sort of thinking got a lot of people into trouble back in the late 1980's and then again going into the GFC when they found that mortgages are nothing like term deposits, their funds got frozen and many made losses. This was not only in managed mortgage funds, but in more direct mortgage investments as well (e.g. via solicitors funds).
If they were like a term deposit you could NOT be earning 9%!!!! You are earning more than the 4-5% on term deposits because of the risks they're taking. The risks of a loan defaulting, the risks that 60% LVR might not be enough to prevent some losses in a foreclosure situation, the illiquidity risk of not being able to get your capital back quickly if you want it.
These are tail risks to be sure - they don't happen often, so the providers of these schemes can make claims like 'no one has lost money in our fund'. But that doesn't mean it can't or won't happen. And the thing is, when it does, the consequences are severe.
I've been responsible for mortgage funds over my career. At Colonial First State we had the largest non-bank mortgage book in the country and at UFS we invested in them for balance sheet and in a managed fund. I believe that commercial mortgages are a perfectly good investment, but not because they are as low risk as you think. They have a place in a diversified portfolio, but the amount you have in them has to be influenced by asking yourself, 'if the proverbial hits the fan with this asset class, is it going to ruin my portfolio - and my lifestyle?' If the answer is yes, then restrict the % severely. If the answer is no, then you've probably got enough. But please don't kid yourself that just because nothing has gone wrong, at least recently, that nothing can go wrong.
At the very least, please stop confusing them with term deposits. They only thing they have in common with TD's is that they pay interest.

Jane
November 26, 2023

Great informative article thankyou and the comments section is just as interesting

Mike
November 25, 2023

Any suggestions as to which banks make it easy to set up T/Ds for a SMSF and a small family trust ? My experience to date has been an absolute nightmare. Bank staff in branches don’t seem to have a clue referring you to on-line accounts. Good luck with that idea.Bankwest doesn’t want to know about family trusts. Any assistance would be appreciated so the above structures can grab some of the best rates in over a decade.

Marc
November 25, 2023

I had the same trouble with my SMSF and ended up with CBA which offered lower term deposit rates than some of the smaller banks

Wombat
November 26, 2023

Great read….. just what I needed as I’m about to retire and some cash placement ideas is helpful.
Thanks ??

BeenThereB4
November 25, 2023

I agree with Nicholas's comments on Hybrids.

I have invested in Hybrids since the issue of (the infamous) NABHA. The terms are complex and they are not everybody's cup of tea but my recollection is that all leading bank hybrids sailed through GFC without missing a dividend.

Jenny Winthrop
November 24, 2023

Thanks for the article, James. Tend to agree on hybrids - too complex and open to regulatory risk for me.

Paul
November 24, 2023

Best income asset for your portfolio and no mining companies?

Jake
November 24, 2023

He did talk of regular and consistent income, and that mining companies didn't fit that criteria. And he's right.

Nicholas Chaplin
November 24, 2023

The problem with the term deposit rates shown are they are all minimum 12 months. Rates will inevitably rise within the next 12 months meaning not only are you losing real money factoring in inflation (as you note), you are also fixing a lower rate into the future. Shorter terms such as 3 to 6 months (as you did yourself) are much better options at present. Your take on Hybrids is unnecessarily harsh. APRA's Discussion paper on AT1 is interesting but I feel they will change other things like capital triggers rather than stop dividends for no reason - remember the Australian banks are some of the strongest and best regulated in the world. Further, the regulator won't do anything with AT1 without doing something to ordinary equity first. That's right - shareholders lose everything first! This is all on the basis that, say, a bank like Commonwealth Bank is about to collapse. Think about the real likelihood. Saying Hybrids are relatively new without experiencing a full economic cycle is outrageously incorrect. I have been structuring hybrids and educating on them for the Australian market since 1998. They went through the GFC beautifully and equities were still trying to recover from Covid a year after Hybrids. 

SMSF Trustee
November 23, 2023

What's ''inevitable'' about rates rising over the next 12 months? That's a highly contestable statement. Lots of macro factors point to a decline in inflation and at least no further rise in the cash rate, or at least only one more before Michelle Bullock wakes up to the fact that the cost of a haircut is not enough to run monetary policy on!

I've been extending the maturity of my TD's in my SMSF from an average of 6 months to all of them now being 12 months. I use bond funds for longer duration exposure, recently adding to that when the 10 year Australian government bond yield got very close to 5%. With inflation heading back towards 3%, that's a very decent real return in my view. (Mind you, with yields having now fallen to less than 4.5% I might just take some out of those bond funds and lock in my gains. That's something you can't do if you extend duration using term deposits, though they don't adjust quite so rapidly as bonds do.)

As for hybrids, I prefer a mix of shares and corporate bonds because the pricing of hybrids includes middle man fees, so the mix gives me a better overall result.

Stephan E
November 23, 2023

The GFC was barely a blip for the banks. A full stress test for banks and hybrids is still to come.

Former CEO of a small financial institution
November 24, 2023

You are absolutely kidding! With hindsight, the GFC did not produce worst case outcomes for banks, because of the policy responses that provided systemic support when it was needed. But having been an investor in them and a counterparty of them at the time, it was hugely stressful. We came within a few days of customers turning up at their ATM and no money being there. Thank goodness that we had folk like Glenn Stevens (and Ric Battelino on his team) at the RBA and Ken Henry at Treasury who were on top of the situation and responded promptly.

So you could say that the results of the extreme stress test were that prompt, effective financial policy responses were enough to support the system even under an incredible amount of stress.

Stephen E
November 25, 2023

Warren,

Kinda missed my point.

The major banks sailed through the GFC compared to those in the rest of the world. For instance, CBA 2009 underlying profits (to June) were down 3% compared to 2008. That's hardly a stress test, compared to the likes of the 1990s when major banks went under, and Westpac went close.

Hybrids need to be tested further to prove enduring in my view. Others can disagree.



Former CEO of a small financial institution
November 25, 2023

Stephen E

Not sure who you think I am, but you missed my point. The banks only got through the GFC because of government and RBA policies in response to enormous stress on their funding. It ended up not hitting their bottom lines hard but boy it nearly did. No bank trusted another for several weeks and global funding sources were drying up. But the RBA pumped liquidity and the government guarantee stopped a run by ordinary customers. So it all ended up OK. That doesn't mean there wasn't a severe stress test.

DE
November 26, 2023

I agree with the former CEO’s view of the GFC. I was a director of a bank (not big 4), and the event was extremely stressful in that role.
The actions of the government agencies in guaranteeing the bank deposits was critical but just in time to prevent a much bigger issue.
I was also a director of major ASX listed companies who had to deal with the actions of big 4 banks as they raced to address the issues.
For one a $100 million line to pay for new equipment was cancelled (and the fees not refunded) even though the equipment was due for shipment.
With others standby liquidity lines were unilaterally cancelled - despite the fees for them being paid.
An acquaintance had the loan for the construction of a 3 story building cancelled when level 2 was just completed.
I could go on.
Sailed through?
The swan was paddling furiously and killing its reputation with customers.

Paul Rider
November 24, 2023

Overconfidence in economic forecasting and hybrid robustness, methinks.

Colin Edwards
November 27, 2023

Thank you Nicholas for your wise historical note. I started investing in hybrids around 2012, and continue to do so as part of a broad portfolio. What is really annoying is ASIC/APRA and Treasury deciding that non-wholesale investors (like me) must pay a financial adviser for a certificate before taking up a new hybrid offering, even if investing in that hybrid is simply a roll-over from an existing hybrid investment.

Peter C
November 27, 2023

Judo bank offers 3 and 6 month term deposits as well. You may wish to look at those.
One option is to split term deposits to different terms, eg have 3 month, 6 month. 12 month and 24 month term deposits, so you spread your risk if you get the next interest rate move wrong, (This is not advice, merely an idea).

Phil Pogson
November 24, 2023

My income producing holdings are the likes of MXT, QRI, PL8, MOT and similar.
If you are going to invest for income then the income needs to be robust.

Eddie
November 28, 2023

MOT paying over 10%. We managed and while a risk the fund managers have over 20 years experience.

AlanB
November 24, 2023

The key attraction for small retail investors of hybrids is stability of income. During the GFC and Covid Pandemic many companies reduced or cancelled their dividends, which negatively impacted the income of small retail investors, particularly retirees. Hybrids, however, continued to pay out distributions even when bank dividends fell. The security of hybrid derived income means APRA must consider and minimise the impact of any changes to AT1s on small retail investors.

Design and Distribution Obligations exclude small retail investors from new hybrid issues. Small investors have to purchase on the secondary share market rather than directly from the issuer at a public offer or roll-over when a previous hybrid reaches maturity. DDOs result in small retail investors paying higher prices for hybrids, reducing their benefit. DDOs have allowed institutions and larger ‘sophisticated’ investors to purchase hybrids at a lower issuance price and to profit at the expense of small retail investors.

Limiting or excluding small retail investors from AT1s reduces income security and pushes them into taking on more risky equities. There is a higher risk of loss of capital and income from declining share investments than from hybrid investments.

Small retail investors should again be allowed access to AT1s at primary issuance, by removing, or amending DDOs. The withdrawal of DDOs would be welcomed by small retail investors, particularly self-funded retirees, who purchase hybrids for income, security and diversification.

Colin Edwards
November 27, 2023

Thank you AlanB. You've expressed exatly my grouch of many months, but is anyone responsible listening?

AlanB
November 27, 2023

I would encourge all members of this forum concerned about hybrids to write individual submissions to APRA in response to the public discussion paper on AT1 capital instruments. The closing date for submissions has passed but there may be some flexibility:

https://www.apra.gov.au/improving-effectiveness-of-additional-tier-1-capital-instruments

Peter Thornhill
November 24, 2023

Cash doesn’t come with a franking credit. As an aside, how come SOL has increased it’s dividend for the last 20 plus years? My benchmark remains Cty on the London Stock Exchange. Increased it’s dividend every year for the last 55 years. Has your income increased every year since 1967??

Josh Dinning
April 22, 2024

Weighing up using LICs or an ETF such as VHY.
I have read your book motivated money and loved it. Just seems to be “riskier” using LICs over something that just tracks an index? (Risk in terms of passive tracking vs relying on a person to continue making correct decisions with shareholders in mind)

Can’t decide what to do! Thinking maybe 50% in LICs and 50% in an S&P500 index for growth as I’ll be working full time for another 15 years.

What happens to my capital if a LIC goes “bust”?

Love your work Peter.

Craig Johnson
November 23, 2023

Annuities such as challenger lifetime need to be analised
In my case or age group $100k gets me $7332 Per annum or over 7% for life without inflation protection.
If i put in just $50k shorley a comparable return, ($3666) than 2000 ANZ share at $25 per share, dividends (94c +94c pa.=$1880+$1880 =$3760), but more tax effective in regard to age pension with 60% of asset and return only counted in calculations.
Can you clarify??

Paul McNamara
November 24, 2023

Analised? That's getting to the nitty & gritty isn't it?

Ian
November 27, 2023

I can't stop laughing!

Steve
November 25, 2023

I think annuities need to be clearer on their income return versus returning your own capital to you. A decent chunk of the $7332 is actually your own money. They are not producing 7% income. One of the problems annuities have is the need to invest in "low risk" assets like govt bonds to ensure they don't lose assets in a downturn and hinder their ability to meet obligations. But this leads to lower returns than stocks. To me they seem quite opaque about how much is real return and how much is simply capital return, dressed up as "income".

Dudley
November 25, 2023

"To me they seem quite opaque about how much is real return and how much is simply capital return, dressed up as "income".":

Lifetime annuities - date of demise required.

Term annuities - '100%' capital returned at end of term like Term Deposits. Except for the 'capital loss' due to inflation. Not Government Guaranteed.
https://www.challenger.com.au/personal/products/term-annuities#rates

Dudley
November 25, 2023

challenger lifetime:

Capital only returned at year 13:
= RATE(13.63884273, 7332, -100000, 0)
= 0%

Inflation 5% only returned at year 23:
= RATE(23.47890898, 7332, -100000, 0)
= 5%

Real return 2% only returned at year 50:
= ((1 + RATE(50.3481079, 7332, -100000, 0)) / (1 + 5%)) - 1
= 2%

Geoff
November 23, 2023

That a yield is below the current official inflation rate does not automatically translate into "you're losing money in real terms" - it's not what the official inflation rate is that matters, it's what your personal inflation rate is that is the test for whether you're losing money - that is "real" real terms - not the country average. People adapt financially to tougher times by changing spending patterns. I'm quite happy to park excess cash in a UBank account knowing what's happening with my personal spending.

Dudley
November 23, 2023

"Two of the most popular are Vanguard’s Australian Fixed Interest Index ETF (ASX:VAF) and iShares Core Composite Bond ETF (ASX:IAF). They’re yielding 4.95% and 5.91% respectively.":

Yield to maturity of current holdings within ETF.

Twelve month trailing distribution: ~ 2%, running yields ~3%.

John N
November 24, 2023

Correct. The % yields stated in the article are misleading as they refer to Yield to Maturity and these funds have bonds expiring and new be added.

John Peters
November 24, 2023

YTM to quote bond yields is most common, so certainly not misleading.

James Hall
November 23, 2023

I didn't see any mention of the 'Super Saver' type accounts offered by some banks. Without restrictions: ANZ Plus (4.9%). Some restrictions: Suncorp Growth Saver (5.05%), AMP Bank (5%)

James Gruber
November 23, 2023

Hi Nicholas, On your hybrid comments, I'd argue that the banks, like Australia, did ok through the GFC. And that the banks haven't really been tested in a significant way since the early 1990s crash. The past 25 years has been very kind to them, overall.

DE
November 27, 2023

Sorry James
You lost me with that comment. Those on the inside saw the GFC very differently.
Just ask a director of St George or Bank West. Remember them and their condition post GFC? Both forced into takeover.
The former got zero when it went looking for term money. The rest is history.

Former CEO of a small financial institution
November 27, 2023

Yes, like I said in another comment above, you don't judge the degree of stress that something was under by the degree to which it broke, but by the actions required to prevent it breaking. The actions of the government and the RBA, along with similar steps taken in other countries, proved sufficient to avert the crisis that was most definitely playing out for all of us involved at the time. But the fact that sizable fiscal stimulus and massive liquidity injections, plus rapid cuts in interest rates followed by QE on a large scale, and the requirement of a government guarantee for depositors, plus some 'bail outs' (eg BoA taking over Merrill Lynch in the US and CBA taking over BankWest, then owned by HBOS, in Australia), showed that the stresses were very, very real and significant.

 

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