Are income investors at the crossroads?
It’s been the no brainer of the last decade. For investors seeking income, Australian Equities has provided a superior outcome relative to term deposits. The income disparity was at its most extreme a year ago when a 12-month term deposit rate was 0.8% while the ASX300 went on to deliver a 5% income return.
Source: RBA, Iress
However, term deposits rates have skyrocketed over the last year as the Reserve Bank of Australia (RBA) aggressively raised the cash rate to fight off inflation. For the first time in a decade, the next 12 months will likely see a term deposit deliver a similar income return to the ASX300.
This begs the question, should income investors dump their Australian equities and allocate more to cash?
At first glance, it is tempting to switch to cash when the income return is similar. However, income investors should be aware of a few things.
1. Australian equities have franked dividends
International equities are disadvantaged when it comes to income as dividends received by investors are taxed twice. On the other hand, thanks to the imputation tax system in Australia, Australian dividends are only taxed once as they have imputation credits. Hence, the headline income return for Australian stocks understates its true pre-tax yield. In a like-for-like comparison, the ASX300 benchmark offers an additional income return of 1.2% (70% weighted average franking) compared to the income returns of other asset classes. Including imputation credits, Australian shares still offer a superior pre-tax yield of close to 6%.
Source: RBA, FactSet, Iress
2. Term deposit income is more volatile
Australian equities have delivered a relatively consistent income return of around 4.5% over the long term. On the other hand, the 12-month term deposit rate is cyclical as it follows the RBA cash rate that changes based on prevailing economic conditions.
Given the rapid rise in the RBA cash rate, many economists are forecasting an increased chance of Australian recession. Under this scenario term deposit rates will likely fall as the RBA cuts the cash rate to soften the economic slowdown. The bond market is also highlighting that current high short-term rates may not sustainable. At present, the yield curve is inverted, as the bond market expects interest rates to fall over the long term relative to the short term. Historically, the last three yield curve inversions (1988, 2000, 2007) preceded economic slowdowns and eventual cuts in the RBA cash rate.
Hence, while the capital base of term deposits is stable, its income return is highly cyclical. On the other hand, equities have the opposite dynamic. They have a relative stable income return on a more volatile capital base, which can also lead to variability in its income stream.
So, which asset class leads to greater volatility in income cashflows when both income return volatility and capital volatility are both considered together? 35 years of evidence shows that income cashflows from term deposits are far more volatile than from equities by a very wide margin.
One of the worst financial disasters in history, the Global Financial Crisis, highlights this important point. Income from equities fell about 32% from peak to trough while income from term deposits fell 60% around that period.
3. Equities provide income growth and term deposits do not
Investors should not forget that equites provide capital growth, which is a powerful force to grow income over the long term. To illustrate this point at an extreme period in history, let’s compare income generation between term deposits and equities from the late 1980s. During that period, term deposits offered double-digit interest rates while income from equities was at risk of falling as dividends were likely to be cut (and ultimately were) as the economy entered a recession. Was choosing the safety of cash with double-digit interest rates versus equities just before a recession the better choice for income?
The following table highlights capital values and income generated when $1,000 was invested in 1989 in both the ASX300 and a 12-month term deposit. It tracks the growth in capital and income over time (assuming income is not reinvested, and imputation credits are excluded).
Source: Iress, RBA, Vertium
In 1989, there is no doubt that 14% term deposit rates created a huge head start in income generation versus the ASX300 delivering a 5% income return. It was 13 years later in 2002 that the cumulative income generated from equities caught up to the cumulative income from term deposits. That may seem depressing from an income perspective but the capital value from equites also doubled while the capital base from term deposits remained stagnant. Over the next two decades, the capital base for equities continued to grow, which drove income cash flows even higher. Despite the huge head start of double-digit interest rates and equities having their dividends cut during the early 1990s recession the cumulative income generation from equities was 377% versus 140% from term deposits over 35 years.
In conclusion, income investors are now spoilt for choice as term deposit rates offer similar income return as Australian equities. Term deposits may look attractive now, but investors should not forget imputation credits associated with Australian dividends. On a like-for-like basis Australian equities still provide a superior pre-tax yield relative to term deposits in the short term. Furthermore, while cash provides capital stability, the interest rate over time is highly cyclical, which makes their income more volatile than equities. While current interest rates look attractive it is not sustainable in the medium term if the RBA cut the cash rate to soften an economic slowdown.
Over the long-term, equities provide investors with capital growth, which in turn drives income growth along the way. The power of compounding capital with equities leads to greater income over time relative to cash alternatives. Under different time-frames income from Australian equities is a clear winner.