12 Apr 2021 - How Hybrids fit into 2021 Income Portfolios

How Hybrids fit into 2021 Income Portfolios

Campbell Dawson, Director, Elstree Investment Management

24 March 2021

• Income investing in Australia was relatively simple between 1990 and 2015; lots of cash, a few higher yield equities and some property gave stable returns at well above the rate of inflation
• The collapse in cash and TD rates has made things much, much harder
• Just buying more equities doesn't work; volatility goes through the roof
• It is still possible to create income portfolios with acceptable volatility? Yes, you just have to be more diversified
• Hybrids are an essential part of an effective income portfolio. They offer a combination of return, muted volatility and good liquidity that can't be matched by other income and asset classes

"We have seen better days" (Shakespeare)

Australian income investors lives have changed, maybe permanently.

Between 1990 and 2015, Australia was the lucky country. High interest rates meant that it was relatively easy to create income portfolios with good returns and low(ish) volatility. After adjusting for inflation, Australian cash and bonds produced the highest 'real' returns in the world for most of the period since 1990.  After 2015, cash and bond rates started to fall, and income portfolios became a lot harder. In the chart below we've shown the income yield and rolling 12 month return of a typical capital stable/safe income portfolio (50% cash/TD, 30% equities, 20% property).

How good is Australia?

The past 15 years have been great; average income levels were 4%, the annual total return (income plus capital) of the 50%/30%/20% portfolio was around 5.25% p.a. including two pretty severe stress events (GFC and Covid-19). Ex Covid, the portfolio volatility was 5% p.a. which meant that capital changes were within the range of +/- 5% for 2 out of 3 years.

Of course, some years were more volatile than that. The portfolio got towelled during the GFC, but if you went to sleep often enough in the years after that, you probably didn't see the portfolio generate a negative return on a rolling 12-month basis until Covid-19, and even after that it's now back to a flat return for the year.

But the income has halved ... and investors can't cut their spending by 50%

The income yield on the previously impeccable income portfolio is now less than 2%, down from the previous decade of average of over 4%. The obvious dilemma is that investors can't cut their spending by 50%, so they either need to start eating into capital, or take more risk on in an attempt to generate previous income levels.

We've highlighted the dilemma by showing what happens to the previously effective TD/Equity/Property portfolio when you increase the equity component to generate higher income. To get to a 3% income return, you need to increase risk materially. It's a big jump for most investors to almost double their risk tolerance, so there has to be a better solution.

Uncomplicated portfolios don't work anymore

We don't think there are any magic solutions. Investors need to take on more risk, but they need to do it more sensibly than just buying more equities, because even 'defensive equities' lost 35% in the Covid-19 downturn. The solution is more difficult because investors need to buy more stuff. It's not going to be as familiar as the old portfolio and has different risks to watch out for.

Diversify and get the free lunch

It is one of the wonders of investment science that you can mix a bunch of higher return but risky assets but if they are not exactly correlated, you end up with a portfolio that's not as risky as you might think.

For example, combining non-AUD equities with AUD equities produces a portfolio with around 30% less volatility than each individual asset class.  Diversification is the biggest free lunch an investor will ever get.

We think investors should use this free lunch concept to combine a range of income type investments with a range of return and risk profiles and let the correlations work for you.

The table below shows a range of asset types with their return and expected volatility. What should be immediately apparent is that there are a range of assets that sit in the mid points between Term Deposits (which are risk free) and Equities (which are definitely not risk free).

A combination of these asset classes increases the return above a Term Deposit exposed portfolio, but the risk and the correlation benefits result in a less risky portfolio than jumping to a higher equity position.

So, how does it look in practice?

We created a portfolio with 10% cash holdings 20% Hybrids and the balance evenly split between the other 8 asset classes mentioned above. Only 35% was allocated to equity and property. We've detailed the return and volatility of the portfolio on the table below and compared them to the "capital stable" of last decade.

It's interesting to note (with the caveat that we have made assumptions about volatility and correlations) that if you diversify your income sources, you can create a c4% income portfolio while still having an acceptable amount of volatility. The previous optimal portfolios either produce less income with the same risk, or the same income with more risk. Neither are particularly palatable outcomes. 

The one trade-off is liquidity.  Most previous income portfolios were very liquid with up to 90% invested in cash and term deposits and with lots of that in TDs which are able to liquified at face value.

The more diversified portfolio has a greater proportion of assets in classes that are either less liquid or more volatile, so selling in crisis results in a discount.

The liquid, non-volatile component is around 30% of the portfolio (cash and hybrids) with a further 25% in listed equities and listed property, which are liquid but maybe not at close to face value.

Why are Hybrids so important?

Hybrids are really important in new age income portfolios for two main reasons:

• They are about the next asset out on the risk spectrum from cash/bonds, but still offer a c3% increase in income.
• Unlike most of the asset classes mentioned above, Hybrids have very little default risk because the issuers are investment grade and unlikely to get into trouble. Most of the other asset classes have sub investment grade exposures and they default far more frequently. It's not immaterial. If you owned 100 companies with the Hybrid markets credit rating, less than one would have defaulted after 5 years (on average). The comparative for a sub investment grade bond loan or fund is around 10 or 11 companies defaulting in over a 5-year period.
• Hybrids are liquid. Other income assets are either do not freely trade or are subject to price and liquidity problems under stress.

The liquidity benefit is particularly important in a portfolio which is trading off liquidity for return.

More about Elstree:

Elstree Investment Management Limited was formed in 2002 and is exclusively and equally owned by the three executives associated with the company. Since 2003 it has managed ASX listed hybrid portfolios and at the same time developed the Elstree Hybrid Index, which is the only index of post-1999 hybrid prices and returns. The data from the Elstree Hybrid Index extensively for security selection, risk management and benchmarking. 

Currently the firm manages approximately $150 million across a wholesale unlisted fund (Elstree Enhanced Income Fund, minimum investment $500,000) and a number of individually managed accounts.  The Elstree Enhance d Income Fund returned 8.8% (excl franking) for the 12 months to end- February 2021.

Elstree has recently launched the Elstree Hybrid Fund (EHF1), an Exchange Traded Product (ETP) version of the successful unlisted Elstree Enhanced Income Fund for retail investors.  EHF1 will shortly commence trading on Chi-X (Chi-X: EHF1).  For more information visit www.elstreehybridfund.com.au.