The key to maintaining sustainable income in the current market

Australian investors are some of the most income-dependent investors in the world. While we talk about the advantages of the rising interest rate environment to retirees, it’s easy to forget that these investors are also trying to maintain purchasing power in an inflationary environment. Even with inflation seemingly declining, those groceries are unlikely to get any cheaper.

In addition, share price increases—particularly in the much-loved banks—have meant that dividend yields have fallen overall.

But what is the alternative for investors desperate to keep their pricing power?

Marc Jocum, Product and Investment Strategist for Global X ETFs, believes improving diversification and investigating the wider capital structure can help investors with their yield profile, particularly when you consider Australian banks.

“Most Australians are just familiar with one type, being the share market or potentially the term deposits that are within an Australian banking capital stack. 

But there’s this whole layer in between that you can get exposure to: senior bonds, subordinated bonds and hybrid securities,” he says, pointing out that many of these have a higher yield profile compared to term deposits or even bank shares.

He also notes diversification has been the key to enabling more frequent distributions – monthly, compared to the traditional cadence of quarterly or half-yearly, in the new Global X Australia Banking Credit ETF (ASX: BANK).

In this episode of The Pitch, Jocum explores improving your yield profile and diversification using bank credit and structuring to receive monthly distributions, and discusses the new BANK ETF.

Please note this interview was recorded on Tuesday 3rd September 2024.

Edited transcript

Can you talk me through how the BANK ETF can help improve your yield profile and offer diversification?

There’s two elements there.

The first is around that diversification mix. Instead of investing in one particular fixed income security, an ETF – like the Global X Australian Banking Credit ETF (ASX: BANK) – gives you access to three different types of fixed income securities, and it gives you access to securities across the broader capital structure of a bank.

Most Australians are just familiar with one type, being the share market or potentially the term deposits that are within an Australian banking capital stack. But there’s this whole layer in between that you can get exposure to: senior bonds, subordinated bonds and hybrid securities. So that really provides that diversification mix.

And because you're actually going down - not too much the risk curve, but you're exploring the wider capital structure, you're exposed to securities that actually have a higher yield profile than you could get within your term deposit, or sometimes they're actually yielding more than what you get by investing in banking shares. 

We've seen the likes of CBA share prices increase over the last year or 12-18 months driving a lot of the share market returns. That's actually meant that their dividend yield has fallen overall. For investors looking to enhance their yield, but also looking to maintain a balanced risk profile, the BANK ETF could be a strong value proposition for them.

Australian investors are some of the most income dependent in the world. Do you have a view on whether distributions and dividends can keep up the flow?

If you look at Aussies, we love our income.

Over half of the return in the Australian share market has been generated from dividends versus if you look at our global peers like the US, only 20% has been driven by their dividends, and that's because the capital growth has been a huge element over there.

I do believe that because people gravitate towards Australian market as a source of income that the yields can be maintained. That being said, we have seen a bit of a yield compression environment, not recently as bond yields have risen, but over the last 10-20 years. So that's pushed people out on the risk curve to higher-risking assets that are paying higher yields. Now with bond yields yielding something and the income is now back in fixed income, that could change. But overall, the demand for income is huge within Australia.

The ASX did a great investor study last year where they looked at all the different age cohorts within the Australian investor landscape, and they found that the number one reason people want to invest is to create and build a sustainable income stream. Income is front of mind for investors, and it's no surprise given cost of living that we are going through at the moment. 

People need to maintain their purchasing power and income - all very important at the moment, and it's great that ETFs provide a great access point to people who are interested in getting income generating assets.

How much do you need to watch interest rates for the portfolio?

I've always been of the view that instead of predicting it's better to prepare. A lot of people try to time interest rates movements, and with a product like this, you're getting exposure to about 80% of the portfolio into floating rate instruments versus fixed. And that means that if interest rates do fall, generally when the bonds reset, their yields will actually fall as well. That being said, it does have a little bit of duration in the portfolio, so if yields do fall, you could see a bit of capital gains within the fixed part of the bond portfolio.

It's important to monitor overall, but I've always been on the view that it's very hard to predict what's going to happen with interest rates. There are different metrics people need to look at. You need to look at what's happening with credit spreads, default rates, where bond yields are at, and sometimes it's best to adopt a level of intellectual humility and actually say, ‘you know what? I'm actually comfortable not knowing what's going to happen in the future’ and outsourcing it to a diversified rules-based investment like the BANK product could be a really good value proposition because you're not necessarily being a price maker, you're actually being a price taker, and sometimes that can be a really good part to having the portfolio from a diversification perspective, but also from a simplicity perspective as well.

Why has Global X chosen to make distributions monthly as opposed to the traditional 3-6 monthly cadence?

What’s great about the product is we built it from the ground up. We went to our clients to seek feedback around what they would want in a product, and income regularity was a really big focus. If you look at the broader ETF universe within Australia, particularly within fixed income products - and there's over about 70 fixed income products at the moment - that has grown massively since they first introduced in 2012. Over half of the products don't distribute monthly. They distribute quarterly, semi-annually or even annually. So, we saw a nice little gap in the market that we could bring a product to market that does fit that income profile that people are interested in. And because you're getting diverse exposure to multiple securities that have different coupon payments, different payment cycles, we were able to offer this monthly income.

It's not going to be the same every single month. Some months may be higher, some months may be lower, and that's because generally the securities within the portfolio actually make their coupon payments at different times.

For example, the hybrid securities may distribute at the end of the quarter. You could see a little bit of a lumpier distribution in there. But that's what's great about the ETF wrapper is that once the underlying securities distribute either their earnings, their income, their coupon payments, it goes right to the end investor. That's why we decided to come up with a product that provides a trusted source of income delivered to clients on a monthly basis.

What features have you had to build in to ensure regular distribution?

For us, it was about having a wide range of issuers. We worked with the index provider to have certain eligibility requirements, whether it comes to the size of the underlying bonds, the credit quality of the underlying bonds -They have to be at least a minimum of investment grade. But also only being exposed to regulated authorised deposit taking institutions, meaning just Australian banks. There are some ETFs out there that have exposure to foreign jurisdiction bonds, also known as kangaroo bonds. But we really thought that Aussies want trusted sources of income.

And when you think about trust, the Australian banks are literally the bellwether of the industry. They have some of the highest capital ratios compared to other global peers. From a risk perspective, S&P do some great research around what's called their BCRA scores, their banking industry, country risk assessment scores, and they found that Australia is one of the least risky when it comes to the Australian banking sector.

David Murray, back in the 2014 financial system inquiry, wanted Australian banks to be unquestionably strong, and that's what they've done. They've improved their capital ratios, they've improved their balance sheets. So for us, having those built-in rules around issuer diversification and minimum eligibility requirements in terms of the bonds was very important with building a product like this.

You mentioned the distributions may vary from month to month on average, what might an investor typically expect?

When building this product, we wanted to try and maximise the level of yield that clients were interested in, but without going too much on the risk curve. And that's how we came up with this idea of having 40% in senior bonds, 30% into subordinated bonds, and 30% into hybrid securities, because that's what maximised risk-adjusted income and was really important for us.

If you look historically, it's yielded from a running yield around about 6% per year, and that's pretty attractive in this environment, given that the Australian share markets yield is now hovering around about 4-4.5%. Once you include franking credits, probably one of its lowest levels in the last four to five years, and governed bonds recently are sub 4% as well. Aussie banks have reduced their term deposit rates more recently. For people looking for a pretty decent level of income, but not taking too much risk in terms of other asset classes that may be providing eye-watering double-digit returns, it's a really nice, comfortable environment, particularly if the interest rate cycle here continues to stay relatively stagnant, the banks have priced in rate cuts.

Whether that happens, the market's pricing in February 2025 for the first rate cut. At the moment, there could be a flight of capital that actually comes to Australia given the higher interest rate differential compared to global peers. A product like BANK yielding around about 6% from a running yield perspective is a very attractive value proposition for investors.

Learn more

BANK is the only index based ETF offering exposure to the broader capital stack of Australia’s banks in one diversified solution. BANK expects to pay monthly income and its index has historically offered higher yields than term deposits, government bonds and corporate bonds.

ETF

Global X Australian Bank Credit ETF (BANK)

Australian Fixed Income

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