Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 305

The role of bonds and hybrids in franking loss

Most of the discussion on Labor’s proposed changes to franking credits has focused on how retirees and investors in SMSF pension phase might experience a significant fall in their (after-tax return) income.

Little has been written about the impact on bonds and hybrids and the solution they may provide. It is also a timely reminder to assess regularly the asset allocation and balance of investment portfolios. The current environment provides a unique opportunity to potentially decrease risk and increase overall return with a reallocation between cash, bonds and equities.

Currently, individuals and superannuation funds are entitled to a refund of franking credits if the franking credits plus any PAYG tax paid by the individual or fund exceeds their tax liability. Under Labor’s proposal, with some exceptions such as the ‘pensioner guarantee’, refunds that exceed tax liabilities will no longer be available for most taxpayers.

Potential loss of income

The practical implication is that retirees and in particular SMSFs in pension phase are most at risk of losing significant franking credit cash refunds. This can reduce after-tax dividend income by up to 30%.

For example, an SMSF in pension phase (hence 0% tax rate) with a share portfolio of $1.5 million earning a dividend yield of 6.0% plus franking would currently be entitled to a refund of $38,571.43. Under the Labor proposal, this entire refund could be lost for some investors.

$1.5 million x 6.0%/(1-30% tax rate)

= $1.5 million x 8.57% fully franked dividend

= $128,571.42 of which $90,000 is received in cash and $38,571.43 in franking credits.

How hybrids are different

The same SMSF with $1.5 million in franked hybrids paying 6.0% (inclusive of franking), as opposed to dividend paying shares, would have lower overall income and franking refund component.

This is because the market quotes share dividends as a yield before franking whereas hybrids are quoted inclusive of franking. A 6% dividend on say a bank share is actually 8.57% (or 42.9% higher) when franking is added. A 6% fully franked hybrid pays $63,000 in cash income and $27,000 in franking credits. The latter is at risk of being lost to some investors.

$1.5 million x 6.0% (inclusive of 30% franking credits)

= $90,000 fully franked distribution, of which $63,000 in cash i.e. 6% x (1-30% tax rate) and the balance of $27,000 i.e. 6% x 30% tax rate in franking credits.

The role of bonds and hybrids in limiting the impact

Individual circumstances vary, including the entities and tax structures available, and other articles in Cuffelinks have described alternatives to reduce the impact of a loss of franking. See, for example, Steps SMSFs may take to beat Labor’s franking, On franking, all public funds are not the same, Labor franking policy will change behaviour, and How SMSFs can utilise franking credits under Labor .

There are also a number of strategies specific to bonds and hybrids which have received little commentary. In particular, bonds and hybrids can provide effective solutions for those who need to maintain high income levels. Options include investing in:

A high-income bond portfolio. Bonds do not have any franking credits and a relatively conservative bond portfolio can be tailored with returns of 6-7% p.a. For investors comfortable with sub-investment grade bonds, the ability to construct a high-yielding portfolio of 7%-plus is possible as there are a number of bonds with returns in the high single digits including 6-12-month senior secured property bonds with low Loan to Valuation Ratios around 50%. A number of foreign currency bonds also come with high running yields such as the Citigroup USD 3mth Libor+6.37% and the NCIG 12.5% USD bond (but these also carry currency risk).

Indexed annuity bonds which pay down principal and interest over their life. These are typically issued by very high-quality A, AA and AAA rated government or public private partnership (PPP) entities and are also indexed to inflation, providing excellent protection. The downside is that at the end of the term the capital value has been completely exhausted but they are a good vehicle for those looking to enhance the cash return received each quarter

Hybrids that pay no or minimal franking credits. Two of our favoured AUD investments across the bond and hybrid market are the ASX listed National Income Securities (ASX:NABHA) and Macquarie Income Securities (ASX:MBLHB). These legacy Tier 1 hybrids were issued in 1999 and neither has any franking attached to their distributions. We expect both of these securities to be redeemed for $100 before 2022. While the running yields are 3.6% and 3.8% respectively, with the current prices in the high $80s, yields to call of over 10% are expected, adding to the consistent 10-15% annual return each has provided since early 2016. Repeating, none of the return includes a franking component. A number of ‘new style’ Basel III-compliant hybrids are also available with minimal or partial franking credits including those issued by AMP and Macquarie Bank.

Over the years we have often written that we do not subscribe to the view that ‘all hybrids are bad’. Rather we suggest investors consider the specific risk and return parameters of each security (including the impact of franking credits). At present, we still see value in legacy hybrids with no franking credits but generally believe new style hybrids are a touch expensive given the risk of a possible sell-off following a Labor election win. However, should credit margins on new style hybrids approach +5% again, we would most likely see value outweighing those risks.

An opportunity to review portfolios

The Labor franking policy provides an opportunity for investors to consider not only their tax position but also their overall investment portfolio balance. As a general rule, most Australians (and in particular SMSFs) are over-exposed to property, equities and cash. On the flip side, we have one of the lowest exposures to bonds of all OECD countries. Direct investment in bonds (as opposed to via a managed fund) is less than 1% across the SMSF sector.

With cash rates at 1.5% and market predictions of further RBA cuts, term deposit rates are likely to have a ‘1’ handle for some time. After factoring in inflation, many cash positions generate a negative real return. Large cash positions represent a drag on portfolios that can be replaced with a variety of bonds yielding 3.5-6.0%. If Labor’s franking policy is enacted, investors could reduce risk and volatility and maintain or even increase (after-tax return) income by re-assessing their allocation to bonds and select hybrids.

 

Justin McCarthy is Head of Research at BGC Fixed Income Solutions Australia, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual. Investors should consider their risk appetite and product knowledge and seek financial advice before taking action. 

For other articles by BGC Fixed Income Solutions, see here.

9 Comments
Greg
May 12, 2019

It is my understanding that Macquarie Income Securities (MBLHB) do not qualify as Tier 1 capital. Is the expectation of redemption prior to 2022 based on this fact. On the flip side these securities are perpetual and paying a low rate of interest compared to other hybrids. Wouldn't it be attractive to the bank to just use them as a cheap funding mechanism compared to other forms of finance and not redeem the securities, regardless of the Tier 1 capital issue? Has the bank made any public comments indicating that redemption is likely or a possibility?

Justin McCarthy
May 15, 2019

The MBLHBs currently count partially towards Macquarie's capital ratios but from 1 January 2022 they will no longer count towards capital ratios at all. This is the main reason we expect them to be called/redeemed before 2022. It is possible that Macquarie will decide to keep the MBLHBs outstanding but when assessing the total cost to Macquarie you need to consider that they cannot use franking credits to pay for any of the coupon (as is typically the case for new style hybrids) and depending on the ATO classification as debt or equity, Macquarie may not be able to claim a tax deduction for the interest paid. On balance we have assigned a 90% probability of call/redemption before 2022. Macquarie has not made any comment on their call intentions which is very typical of financial companies and callable securities.

Phil
May 10, 2019

A relatively conservative bond portfolio with 6-7% per annum returns? I would like to see the constituents. Is this income or total return? And the expected growth component is based on an assumption on interest rates of x?

Justin McCarthy
May 15, 2019

There are many ways to structure a bond portfolio to suit individual needs. A very high quality/all investment grade portfolio with income (or 'running yield') of 6-7% could be constructed by focusing on high coupon fixed rate bonds, however the overall yield to maturity would be closer to 4-5% as many of those high income bonds are trading over par. When talking about a 'relatively conservative bond portfolio with 6-7% per annum return' we would be looking at a mix of fixed and floating rate bonds, using the current market assumptions for future interest rates. The expected yield to maturity or total return is 6-7% with approximately 5% from income and the balance from anticipated capital gains from a small number of selected securities such as the investment grade ASX listed NABHAs. Investment grade/sub-investment grade mix would be approximately 70/30. Constituents would include names such as NAB, Macquarie Bank, Barclays Bank, Members Equity, SBS Bank, NextDC, Centuria, QBE, Citigroup, AT&T, Incitec Pivot, ASCF, AFC and MoneyMe.

Gary M
May 10, 2019

Hi RJM, I think we are talking about different things. You are saying you will lose your franking credit. I am saying that even after using all my franking credit, I still pay tax. So I will be unaffected. I pay tax. I would love my 'tax return to be lost', but they will still come looking.

Gary M
May 09, 2019

Difficult to know whether other hybrids will fall in price if Labor is elected. The market has had enough warning, and I saw some numbers recently that the majority of SMSF are still in accumulation, and therefore can use the full franking.

RJM
May 09, 2019

SMSF accumulation are taxed @ 15% / Franking credits are ~ 30%

Therefore (indicatively) accumulation SMSF can only utilize half of their franking credits, the other half are lost to a greedy inefficient labor government to waste.

Gary M
May 09, 2019

RJM, they are no lost. Tax is paid on contributions as well as income on all assets, so the franking credits earned on Aussie shares can cover all this. In fact, I have a large, diversified SMSF and I utilise all my franking credits and still pay tax.

RJM
May 09, 2019

Hi Gary: I also have a SMSF in diversified Aus shares in accumulation and also currently get a Tax return that will be LOST.

 

Leave a Comment:

     

RELATED ARTICLES

Apparently, retirees should learn to SKI

A frank look at Chris Bowen's $67,000 question

Franking policy may increase corporate tax avoidance

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.