Is it time for SMSFs to shift investment gears?

The recent interest rate cut by the Reserve Bank of Australia has created a number of opportunities for self-managed super funds. Peter van der Westhuyzen explains.

With the Reserve Bank of Australia (RBA) cutting the cash rate recently, and the possibility of further rate cuts in the near term, self-managed super fund (SMSF) investors now have the opportunity to change gear in their investment strategy to make the move out of cash.

A leveraged solution may help SMSFs get the most out of Australian equities which right now are delivering attractive dividend returns and franking credits.

While leveraging into shares can magnify losses if the market falls, it can also help diversify your portfolio and generate long-term returns, even if equity markets remain flat for the next three to five years.

With historically high dividend yields and franking credits, there is currently an opportunity for SMSF investors with the right set of circumstances to generate returns by leveraging into some of Australia’s largest listed companies.

Investment and returns from cash are now slowing

On 1 November, the RBA lowered the cash rate for the first time in over two years from 4.75 to 4.50 per cent. This shift in RBA monetary policy comes at a time when deposits on the Australian books of individual banks had increased by over 16 per cent in the two years to September 2011, rising from $1.23 trillion to over $1.43 trillion.

During that time, the average Australian household saving rate had also been on the increase, with the average Australian saving almost twice as much of their household income than they were five years ago.

This recent attraction to cash has been quite appealing for investors. Many investors are shifting their investments into cash to take advantage of its perceived safety, and returns from term deposits that are being offered by some with interest rate premiums of greater than 1.50 per cent over the RBA cash rate. 

However, the RBA’s November rate cut has potentially put an end to that party.

In addition, two-year Australian bond yields are pointing toward further interest rate cuts over the next 24 months. It is likely that this expectation has contributed to a noticeable slowdown in the rate of growth of deposits held on the Australian books of individual banks in September 2011, compared to the previous two months.

With such a large amount of cash sitting on the sidelines, it is worthwhile reconsidering Australian equities as an investment class. 

Why consider a shift in investment strategy?

The stock price declines in many of Australia’s largest listed blue chip companies over the past 18 months have seen dividend yields on a number of ASX top 10 listed companies increase to levels not seen since the early 1990s and immediately after the global financial crisis.

In fact, the average dividend yield on the ‘big four’ Australian banking stocks has recently traded at a premium of over 5 per cent relative to the rate of return on two-year Australian government bonds, for only the third time in the last 20 years (see Chart 1). 

For some of Australia’s largest blue chip companies, dividend yields when grossed-up for franking credits are trading at levels above 10 per cent, providing SMSF investors with the ability to use leverage as an opportunity to generate returns even if stock prices remain flat over the next five years (see Chart 1).

Incidentally, if one had purchased shares in any of the ‘big four’ banking stocks over the last 20 years on a day in which the stock traded on a dividend yield with a premium of five per cent or more over the two-year government bond rate and held the investment for five years, the average annual capital return (unleveraged, and excluding dividends) would have been 21.5 per cent.

On all 548 occasions in which that investment opportunity was available (ie between 1991 and 2006), a positive return would have been returned 100 per cent of the time.

Of course, it is important to remember three important investment principles: past performance is not necessarily an indicator of future performance and should not be relied upon as such; there are no guarantees when investing; and any investment decisions must consider not only the potential for gain but also the risk of loss.

Case study

Tan and her husband Philip are trustees of their family SMSF. They, like many investors, have a historically high percentage of their total SMSF assets allocated to cash. Anticipating further cuts to the official cash rate, Tan and Philip would like to take advantage of the high dividend yields currently available in Australian banking stocks.

After assessing their risk profile, they are comfortable taking on the risk of leveraging into equities through the use of a leveraged investment product. They also understand that the use of leverage can potentially magnify gains as well as losses.

Tan and Philip use an instalment receipt to leverage half the amount of a $100,000 investment into ‘big four’ Australian banking stocks. They determine that they are prepared to invest on the assumption that the underlying share portfolio achieves zero capital growth over the next five years.

Other key details included in Table 1.

The returns analysis

By using an instalment receipt, the SMSF is entitled to the dividends and associated franking credits (subject to the SMSF’s particular circumstances) based on the entire investment amount (ie $100,000) and not just on the cash contributed. 

In Philip and Tan’s case, their investment strategy immediately generates income for their SMSF. The income earned from the dividends and the franking credits results in the investment being cash-flow positive within the first year.

Over a five-year term, the SMSF has during that time generated more than $71,000 worth of dividend income and franking credits for an interest outlay of a little more than $20,000. 

When measured net of cashflows and tax after five years, the value of the investment into banking shares to the SMSF is worth over $92,000, significantly higher than the $50,000 cash initially contributed. This return has been achieved assuming a flat equity market providing zero capital growth. 

Conversely, assuming negative capital growth each year over the five-year period, the underlying prices of the shares purchased would have to fall by 12 per cent per annum (or roughly halve in value during that time) for the final value of the leveraged investment in equities to be worth roughly the same as the initial $50,000 cash contributed.

This provides a significant downside buffer if Tan and Philip are concerned about a falling share price environment. However, it will expose them to increased losses if share prices fall by greater than that amount (see Table 2).

So, which product do I buy?

A number of leveraged SMSF products offer ‘built-in protection’ features, such as loan protection or put option fees. While these may appeal to some, protection comes at a cost.

In some instances, loan protection premiums, often paid in advance, can cost as much as $4,600 on a $50,000 leveraged amount, requiring the underlying portfolio to generate a positive return just to earn back that ‘protection premium’.

Instalment receipts, on the other hand, can offer SMSFs a lower-cost alternative to use leverage in their investment strategy.

Instalment receipts generally have a loan-to-value-based early repayment trigger and may not protect the starting value of the underlying investment portfolio.

However, they are generally limited recourse obligations, meaning that the SMSF’s exposure is limited to the initial amounts invested and any additional amounts that the SMSF elects to pay in response to an early repayment trigger.

Instalment receipts may not come with all the bells and whistles of some other leveraged SMSF products.

However they can provide the SMSF with a high degree of transparency and liquidity, and access to the benefits of leveraged investing (such as dividends and franking credits). At the same time, they also have the potential to fulfil the investment objective of getting from A to B without the high expense.

When it comes to investing, being able to arrive at your destination should be the primary consideration. After all, there is no point shifting gears if it isn’t going to get you to where you want to be.

Peter van der Westhuyzen is the head of Macquarie Specialist Investments.