You do not need me to tell you that financial markets are experiencing ‘interesting times’. From what appeared as a full-on recovery in the economy and positive outcomes for investors late last year and early into the calendar year, we are hearing talk of bear markets and even a possible recession. And of course, those blessed with hindsight saw it coming!
A key driver of volatility in markets is uncertainty and we picked up on this theme in the following month with Share Market Volatility. The big uncertainty now is inflation and how central banks globally and here in Australia, the RBA, will manage interest rate policy.
Some investors and SMSF trustees may now be seeing future rate rises as great outcomes, with a return to higher rates on bank deposits providing more income. Others who have taken on higher risk, increasing holdings to equities through the ‘interest rate drought’, may now be thinking of reducing equity holdings in favour of cash and term deposits.
For those new to investing, directly or as a SMSF trustee, there may be some confusion on how volatility in equities can drive the market down, removing gains on paper, especially if exposed to tech and they may now be considering what to do next.
And there is plenty of commentary painting a bleaker future and what to do next by way of ‘here are my ideas on how to beat inflation’ and ‘recession proof a portfolio’.
So, let’s take a look at what may be happening on the interest rate front and whether investors should consider switching to cash from equities on the way ahead.
Last month’s article included a link to the ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve. It provides a guide to the direction and level of where the professional market considers rates are headed. In May, it suggested cash rates around 3.5% in a year’s time. Following the June 0.50% increase in the official cash rate, it is now suggesting rates of around 4.40% next year; pricing in further increases that peak around June/July 2023. Again, please note its disclaimer.
What’s ahead?
Cash and term deposits
Unfortunately for both borrowers and depositors, based on recent experience, rate rises have been added to borrowing rates almost immediately and have taken time to flow through to deposits and not in full.
Our article last month also noted that banks may not be in a hurry to grow their deposit bases particularly from the highest cost source of funds, retail deposits, so deposit rates may lag official rate rises for some time to come.
The risk for those seeking to generate income from a ‘safer’ asset class such as cash, is that with inflation at 5.1% and predicted to head to 7% by year’s end, returns will be less than inflation.
For some the outcome may be to stay with asset allocations to equities currently in place. The risks here maybe the continuing volatility and again returns, while potentially closer to the inflation rate, still falling below it.
Staying with Equities
If continuing to hold equities as part of an SMSF investment portfolio and looking for income, it may seem obvious to say, those investments will need to continue to pay dividends or distributions. What may not be so obvious is that not all companies pay dividends and some may not be able to continue to pay dividends going forward let alone with franking credits.
For an SMSF in pension phase franking is important and while not all companies pay dividends, some that do, do not pay franked dividends.
Of the 200 companies within the S&S/ASX 200 index, approximately:
- 45% pay fully-franked dividends (91/200)
- 15% pay partially-franked dividends
- 20% pay non-franked dividends and
- 20% pay no dividends
It’s important to know which are which and those that have the sustainability to continue to pay dividends and franking.
It’s important to know which are which and those that have the sustainability to continue to pay dividends and franking.
How to identify dividend paying plus franking credit stocks?
The first thing to remember about dividends is that they are not guaranteed and that even if profitable, a company can choose to not pay a dividend or retain it for a range of reasons, such as we saw with banks in early 2020.
Things to consider:
- Profitability – while companies can retain profits and pay out as dividends in future periods, it’s probably wise to see that payouts are equal to or less than current year’s after tax profits. Any from earlier periods are sometimes paid as ‘special’ dividends and not reflective of future payments.
- Tax paid in Australia – companies making profits in and paying tax in Australia can attach a franking credit to dividends. For those companies that earn some
revenue outside. Australia and pay tax in other jurisdictions, dividends may be only partially franked, while for those that pay no tax in Australia; a dividend may be unfranked.
-
Payout ratios – some companies specify an amount of profit that will be paid as a dividend. This can be as a guideline percentage or within a range. It should be noted that it is not a guaranteed payout ratio and can change.
- Sustainability – companies within certain sectors, such as consumer staples; supermarkets, entertainment for example, tend to be consistent in paying dividends during challenging times, as many essentials and services remain a necessity.
- Structure of the entity – companies are closed-end structures, which allows them to hold past profits on balance sheet for future use. This can be used to contribute to the company’s operations or to pay to owners when the ‘excess capital’ is not required. It’s important to remember companies are focused on running a business and paying back capital to owners may not be a priority set by management if seeking to grow the business.
With investment products such as Listed Investment Companies (LICs), their business is paying dividends and franking credits to owner investors. Often an LIC will retain profit and its attached franking on-balance sheet for future payment more by way of streaming a consistent flow of franked dividends over time. This is unlike unit trusts such as ETFs, which cannot retain profits (and franking) and must pay this to investors and if income in one year is reduced, distributions (income to unit holders), will also be reduced.
Here we are at the halfway point of 2022 and the start of a new financial year. While its timely to reflect on a turbulent 6 months, it’s also important to consider what may lie ahead. We have only touched on a few of the possible considerations that may be before us, some of which we pointed to at the beginning of 2022, but there remain more to be considered.
Hopefully the points above have helped to get you thinking, however, if you need specific help please talk with an accredited SMSF Specialist in your area.
In the meantime, keep an eye on inflation, interest rates and how they impact on your investment’s returns and income.
Until next time, wishing you successful investing.
Ian
Disclaimer: The information contained in this document is provided for educational purposes only, is general in nature and is prepared without taking into account particular objective, financial circumstances, legal and tax issues and needs. The information provided in this article is not a substitute for legal, tax and financial product advice. Before making any decision based on this information, you should assess its relevance to your individual circumstances. While SMSF Association believes that the information provided in this article is accurate, no warranty is given as to its accuracy and persons who rely on this information do so at their own risk. The information provided in this bulletin is not considered financial product advice for the purposes of the Corporations Act 2001.
Source: https://smsfconnect.com/
Guest Contributor SMSF Connect Incestment Series