Is the ‘natural yield’ sufficient?

Article #456 by Edward Rizzo - Published Published Articles

The natural yield of a person’s portfolio (comprising financial investments as well as other assets) represents the annual income received in the form of dividends on shares; interest on deposits at banks; interest on bonds; as well as rental income from investment properties.

Historically, many investors followed the ‘natural yield’ theory of investing whereby investors generated a sufficient income from the assets within one’s portfolio to sustain their standard of living and maintain the capital value of their portfolio.

However, in today’s unprecedented environment, yields on many investments have declined substantially. Idle cash in a current or savings account generates little or no interest whatsoever. Yields on bonds have also dropped substantially and likewise dividend yields have also declined as many share prices have rallied in recent years precisely also as a result of the decline in interest rates.

The natural yield of a portfolio has subsequently declined markedly when compared to the years before the 2008 international financial crisis when yields were far superior to today’s levels. As an example, a 10-year Malta Government Stock used to produce a yield of 4.7% in October 2008. This declined to 4% in 2012 and it is now at just above 0.9%.

The strategy of relying on the natural yield is therefore under threat for people trying to maintain their standard of living only through the natural yield on an investment portfolio. The problem is amplified as a result of an increase in life expectancy.

Meanwhile, although investors who built up their portfolio several years ago are still producing a relatively attractive natural yield, such investors are also experiencing these challenging conditions when bonds (whether Malta Government Stocks or corporate bonds) are maturing (at times also earlier than the final redemption date) and new bonds are being issued at much lower yields. Various bonds (both corporate and Malta Government Stocks) redeem throughout a year and as such, many investors have had to deal with this reality for the past few years. Unfortunately, it is becoming even more challenging as a result of the continued decline in yields as evidenced again with the new Malta Government Stock issue at a yield of below 2% for a 23-year bond!

In the circumstances, a change in investment strategy is required whereby a portfolio needs to shift away from the traditional ‘buy and hold’ strategy and be more actively managed to capitalize on gains and other investment opportunities on an ongoing basis.

A clear example of this is found in certain shorter-dated Malta Government Stocks. The prices of these bonds have increased so much in value that an investor can dispose of the bonds now and take all future interest payments 5 years, 6 years or 7 years in advance. The capital can then be reinvested even if this would mean at much lower rates of interest. In such a way, investors are also protecting the capital value of their portfolio.

A few years ago, I had published an article about ‘lifestyling’ an investment portfolio. Basically, conventional theory dictates that as an investor approaches retirement age, an increased allocation to bonds is normally recommended as many retired persons become more dependent on the income generation of their investment portfolio. The general rule is that the bond allocation in an investment portfolio should equal one’s age. Therefore, a 30-year old starting off an investment portfolio should only retain a maximum 30% allocation to bonds with the balance of 70% in equities and other asset classes. On the other hand, a 65-year old should have a bond allocation of at least 65% with the balance of 35% in equities and other assets.


However, this conventional theory is also under threat and such a portfolio allocation may also not necessarily produce the desired results nowadays due to a decline in the natural yield. Investors may therefore need to change strategy and take on more risk to generate adequate returns (both income and capital gains) from their portfolio.

This change seems to have already started taking place as was evident in the rally in some share prices over the past two years. Many share prices of companies producing sustainable dividends surged on the back of a significant increase in demand for income-generating equities. The equities of companies such as Plaza Centres plc and Tigne Mall plc more than doubled in value while the share price of Malita Investments plc is up around 56% over the level of mid-2014.

Additionally, investors have also become more active participants even in certain investments where they were normally regarded as ‘buy to hold’ investors. In fact, as a result of the low yield environment, investors are piling into bonds at times purely for speculative purposes with the intention of crystallising an early capital gain and not with the aim of earning interest over the duration of the bond. In last week’s article I mentioned the high level of trading activity in the 2.4% MGS 2041 (I) which commenced trading on 23 August 2016. Since the start of trading, a total of €60.4 million nominal of the 2.4% MGS 2041 (I) changed hands on the secondary market, representing 39% of the total amount in issue in this stock. This clearly indicates that a large number of investors have since sold their allotment following the quick appreciation in the price of this 25-year bond. This strategy however entails a significant amount of interest rate or price risk. Investors must not overlook the fact that at some point in time as yields begin to climb again (this is already taking place in other parts of the world such as the US and UK), quick price gains may not materialize and investors may suffer losses by following such short term investment strategies. Once the interest rate cycle reverses, it will also naturally affect those investors holding a sizeable allocation to medium and long-term MGS as prices will decline across all securities. However, last week’s credit rating upgrade for Malta bodes well for continued appreciation of prices of medium and long-term Malta Government Stocks as an adjustment is necessary to bring yields in Malta closer to yields seen across other countries with a credit rating of ‘A-‘.

In view of the requirement for more attractive and stable sources of income, there is a continuing need for other corporate bonds to be offered to investors together with equities producing sustainable dividends. While it is true that there is a much larger element of credit risk when investing in corporate bonds as opposed to Malta Government Stocks, the difference in coupon may somewhat offset the shortfall in the natural yield. This can also alleviate the widespread demand for income-generating securities which is leading to speculative price movements in the first few days of trading following the listing of a new bond.

Clearly, with banks no longer providing savers with an adequate rate of return on their savings, there is a need for new investment opportunities, both from a bond perspective and also from an equity perspective. Hopefully, the important incentives announced earlier this week in the 2017 Budget Speech by the Minister of Finance will encourage many well-known and mature local companies to offer shares to the growing investment community. The re-introduction of the tax exemption on capital gains upon the sale of shares to the public through a listing on the Malta Stock Exchange should instigate many local companies to conduct an Initial Public Offering of shares. Furthermore, the measures being introduced enabling shareholders to claim a refund of the tax at source on dividend income from listed equities with respect to distributions made out of profits derived on or after 1 January 2017 is another interesting initiative that should lead to an increased demand for local equities.

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Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “RFC”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon.

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