The Australian equity market has enjoyed a few good months, though once again it is now facing valuations challenges. Irrespective of how the market deals with this challenge, however, one fact is indisputable: income returns from the market remain very attractive relative to interest rates. Given that local interest rates could fall even further in coming months, this suggests that the high yield equity theme is likely to perform relatively well in most likely market conditions.  There’s even a chance that the equity market could be “re-rated” higher if interest rates remain below historic average levels.

Market Rebounds but Valuation Concerns are Back

As seen in the chart below, the S&P/ASX 200 has staged a feisty come back in recent months, and is again trying to push through 5400 points. The challenge, however, is that the rise has come despite continued weakness in forward earnings, such that the market’s price-to-forward earnings ratio has again increased to the peak of just over 16x seen in early-2015 when the market last ran out of steam.  In fact, market prices remain lower now than in early 2015 – despite similar PE valuations – due to a decline in forward earnings over this period.

Dividends Still Look Attractive

Looking at these margins in more detail, it is evident that the margin between the GDY and these interest rates is currently around 3.75%, which is considerable higher than  (relatively stable) average margin of around 0.75% p.a. between 2003 and 2013.  At today’s level of interest rates, retention of this previous average margin would justify a gross dividend yield of only 3.25%, or almost half the current rate!

But the Payout Ratio Appears Unsustainably High

Does this mean the market is cheap and should simply surge in value to bring down the dividend yield?  Not necessarily.  One complication to this analysis is the fact that earnings have been relatively weak in recent years, and maintenance of a relatively stable dividend yield – in the face of rising equity prices – has required a rising level of dividends, and hence a rising payout ratio.

Indeed, as seen in the chart below, the implied payout ratio – or the ratio of the GDY to the forward-earnings yield (inverse of the forward PE ratio) – has lifted to around 100% in recent months, compared with a long-run average of around 75-80%.   Relative to earnings, the current level of dividends appears unsustainable – either earnings will rise and/or dividends will tend to fall to restore a more normal payout ratio.

Cuts or not, Dividends are Likely to Remain Relatively Attractive

Given that dividend yields remain so high relative to interest rates, however, they are likely to remain attractive even if they’re cut to some degree.  Let’s assume, for example, that earnings hold around current levels for some time, and dividends are eventually cut by 20% to restore the payout ratio to 80%. That would imply a decline in the GDY to 4.9%, which would still imply a substantial 2.4% p.a margin over current 10-year bonds yields and one-year term deposits – all whilst keeping the price-to-forward earnings ratio at its present relatively elevated level of 16.3.

But if interest rates were to hold at current levels, however, there’s even some chance that equity market valuations could be “re-rated.” This is explored in the table below.

Again, let’s assume, as an example, that the sustainable margin between the GDY and interest rates referred to above declines to around 1.5% p.a. (which is still twice that averaged between 2003 and 2013), then the gross dividend yield could decline to 4% p.a.  Assuming an 80% payout ratio, that in turn would imply a sustainable price-to-forward earnings ratio of 20x!

If we allow for a moderate 1% rise in interest rates (to 3.5% p.a.), then keeping all else constant the GDY could still fall to 5%, implying a sustainable price-to-forward earnings ratio of 16x – or not far from current levels.

BetaShares High Yield Funds

Another option is the BetaShares Australian Dividend Harvester Fund (managed fund) (ASX Code: HVST), which aims to provide investors with exposure to large-cap (typically among the top 50 by market capitalisation) Australian shares, along with a strong income stream comprising dividends and franking credits, that is at least double the yield of the broad Australian share market on an annual basis.  In addition, the Fund employs a risk management strategy which aims to reduce the volatility of equity investment returns and defend the portfolio against the risk of significant market declines. Based on the closing value of the Fund as at end-March, HVST had a trailing 12-month net yield of ~12.5% p.a. and a grossed up dividend yield of 16.1% p.a*.

We also offer the BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) (ASX Code: YMAX)  that aims to provide investors with exposure to a portfolio of 20 blue-chip Australian shares (as represented by the S&P/ASX 20 Index).  As well as holding underlying shares, the Fund also employs a “covered call” option strategy which aims to provide a higher level of income and lower overall level of return volatility than would be provided by the underlying share portfolio.  By its nature, the strategy of selling call options implicit in the Fund aims to cushion returns in weak markets due to the regular receipt of call option premiums, although this strategy does limit upside gains somewhat when markets are rising strongly. Based on the closing value of the Fund as at end-March, YMAX had a trailing 12-month net yield of ~10.8% p.a. and a grossed up dividend yield of 13.0% p.a*.