Self-managed super fund (SMSF) investors were left reeling after three of the big four banks slashed dividends across the board, with ANZ and Westpac suspending theirs altogether and NAB cutting its by 64%. CBA has said it won’t make a final decision on its dividend until August when it reports its full year results.
It’s a huge hit for many self-funded retirees, with research from investment bank UBS indicating the dividends paid by the big four local banks account for 30% of all the dividends from ASX 200 businesses.
In the wake of the dividend bloodbath, investors are scrambling to identify alternatives that will generate income in a world smashed by the coronavirus crisis.
Still in the banks
Unfortunately for investors, it’s fairly normal for a bank to cut its dividend during a downturn. It’s also a time when they tend to raise capital, which can also be a problem because it dilutes shareholders’ existing holdings.
“What’s happening now is no different to the GFC,” says Alex Jamieson, founder of AJ Financial Planning.
There is one tool, however, investors can use to combat both declining dividends and dilutive capital raisings. It’s known as an arbitrage strategy. NAB is an example. It’s raising capital under a share purchase plan with a share price of $14.15. NAB’s current share price is around $16.91. So the plan is offering shares at a 16.32% discount.
“There’s nothing stopping retirees who may be in a zero tax environment inside their SMSF taking up their full allocation and immediately selling it to pick up the arbitrage on the price variance. This manufactures dividend-like income for a part of the holdings and allows them to bank a 19.5% return on their investment,” says Jamieson.
Beyond the banks
Arbitrage strategies aside, there are alternatives to the big four banks for SMSF investors that still want their income to come from shares.
Pete Pennicott, a director of financial advice firm Pekada, recommends investors look for businesses with strong balance sheets and cash flows that are growing, or at least resilient to the impacts of COVID-19. “Some of the larger resource companies such as BHP Billiton and Rio Tinto may be worth researching, as they have entered this challenging period with relatively strong balance sheets and cash flows. While not without short-term to medium-term risks, these factors should provide some resilience to their dividends.”
Other sectors to look into would be regulated infrastructure assets whose revenues are mainly unimpacted by COVID-19. Examples of this would be electricity and gas utility networks, which are essential services that generate stable revenues.
Says Pennicott: “Think beyond the short term when looking at opportunities to add new businesses to your portfolio. Look through the immediate hit to dividends to identify quality, long-term, income-generating investments at a good price. Assess business prospects over the next three to five years and don’t be too fixated on the next 12 months. There is a good chance quality businesses’ ability to pay a dividend will recover with proper capital management.”
Outside equities, fixed interest funds are another option for generating income. They can provide exposure to Australian and global government bond markets and debt securities issued by corporates.
“The right mix of these assets can provide relatively stable returns with a low probability of capital loss over the longer term,” says Pennicott.
“Given the level of capital volatility faced by dividend-yielding shares such as the big four banks, an allocation to these assets might provide a more consistent level of income, albeit without the same franking credit benefits,” he adds.
But make sure you fully understand any fixed income investment you buy. The risks attached to these instruments can really vary, depending on a variety of factors including credit quality, duration and currency.
Hybrids, which offer both fixed interest and equity exposure, are also an option for investors looking for income. Banks issue these instruments, which list on ASX, to raise funds for their firms. Hybrids offer a margin above the bank bill swap rate that is honoured by the hybrid issuer and have a fixed end date.
“You can buy instruments issued by ANZ, CBA, NAB and Westpac at a price lower than their maturity value. They pay a much higher dividend as a percentage of the share price than they did when they were issued,” says Angel Advisory director Stefan Angelini.
BetaShares also offers an ETF that gives investors exposure to a basket of hybrids, which avoids the need to pick and choose and also provides a level of diversification.
mFunds are also an option. These are unlisted managed funds available through ASX. Many offer a fixed interest exposure, with both local and global options. Angelini says, “The Epoch Global Shareholder Yield fund is an example of a fund that was able to select businesses that, even through the GFC, all upheld their dividends.” Other choices include the PIMCO Global Bond Fund as well as options from Janus Henderson.
Also consider capital notes and preference shares. These are ASX-listed investments banks and companies use to raise capital for their balance sheets.
An example is Challenger’s capital notes, which are offering a 10.5% per annum yield-to-maturity rate-of-return and an expected maturity date of 25 February 2021. As with any capital note, there are risks attached. It’s important to understand these before jumping into these types of investment to ensure they are suitable for your investment portfolio and risk profile.
Another higher risk option may be peer-to-peer lending. Companies in this space include RateSetter and SocietyOne. “At this point, this is likely to provide the highest income return because the rate-of-return is similar to the commercial lending rate,” suggests Discover Financial Partners’ partner and financial adviser Lachlan Anderson.
This is a high risk option, so carefully consider how much of your portfolio to allocate to this area because the risk of losing your capital is high, especially in this environment.
Impact on retirees’ wealth
The 64 million dollar question is what impact banks slashing their dividends will have on retirees’ wealth. Jamieson says the answer depends on portfolio diversity and asset allocation.
“From an asset allocation perspective, retirees should have around six months’ income in cash plus an additional amount in fixed interest. It’s an asset allocation failing if they don’t already have this in place that would be much more of an issue than any cuts to dividend. Anyone in this situation should review their position,” says Jamieson.
Diversity is also a problem for a portfolio based around the local banks. Retirees usually need 19 holdings across different sectors and industries for a portfolio to be 95% diversified.
Says Jamieson: “Bank exposure in a retirees’ portfolio should be no more than 5–10% of the total portfolio. If it’s more, review whether this allocation is still appropriate longer term.”
He says the hit to the portfolio’s income from the banks’ current dividend cuts should only be between 2–5% if asset allocation and exposure to banks from a weighting perspective is correct.
“So if an investor normally receives $100,000 a year in income, this would drop by only $2,000 to $5,000 for the next 12 months, which should be a fairly minimal impact.”
The message to anyone whose income is really suffering as a result of the banks slashing their dividend is to reconsider whether their SMSF’s asset allocation is really meeting their retirement goals. If it’s not, it’s time to take a good look at what might need to change to avoid this happening in the future.