In the fourth story of a series that commemorates the Australian Securities Exchange’s 150th anniversary in 2021, ASX presents a modern history of income investing on the exchange.

Many investors buy shares for capital growth. But a great trend in ASX’s modern history is the development of markets and listed funds for income investors.

Throughout ASX history, income investors have bought shares for their dividends – a bit like buying a chicken for its eggs. That is even more the case today with bank term deposits paying low returns. 

The S&P/ASX 200 Index – the main barometer for Australian shares – had an indicated dividend yield of 2.8 per cent at end-June 2021.[1] That’s below historical standards, but a lot better than a 0.25 per cent return on one-year bank term deposits.[2]

Over 10 years, the S&P/ASX 200 Index has an average total return of 9.3 per cent each year.[3] The total return combines the price return (capital growth) and income return (yield). Almost half the total return came from yield. That shows the importance of dividends.

With interest rates at record lows[4], investors who hold a large part of their portfolio in cash are earning a negative real return (after inflation). [5] Fixed-income yields have also fallen: the 10-year Australian Government bond yield was 1.2 per cent in July 2021.[6]

A negative real return means investors are going backwards and their purchasing power is being eroded. Investors with $1 million in a term deposit just before the 2008 Global Financial Crisis earned $59,000 in annual income.[7] Today, they might earn a few thousand dollars.[8]

Ultra-low yield on cash is forcing more income investors to take extra risk.[9] For some, that means buying shares directly on ASX. For others, particularly conservative investors, using a listed fund for diversified exposure to income assets can reduce risk.

Income investing is about more than yield. It’s also about managing risk by building and maintaining a diversified portfolio across asset classes. This is especially important for older investors, such as retirees, who want income and capital stability.

Over two decades, a recurring theme in ASX initiatives for income investors has been to provide choice across asset classes. That involves four main areas:

• More ASX-listed companies in sectors that suit income investors
• A larger fixed-interest market
• A vibrant market of listed funds that focus on income
• Access to unlisted income funds through mFund

Rise of income investing

To recap, ASX is presenting a series of essays this year on its modern history. We’ve chosen 1998 as the starting point for this series because that is when ASX became the world’s first exchange to demutualise and list directly on its own exchange.[10]

Few topics in this series are more important than income investing, and not only because of low interest rates and demand for higher-yielding shares. 

Like other developed nations, Australia has an ageing population and many self-funded retirees who rely on their investment income to live, or supplement other income.

Compulsory superannuation has made Australia the world’s fourth-largest pension pool.[11] Our superannuation sector is projected to be worth $10 trillion in 2038, from $2.7 trillion in 2020. [12] That means a lot more capital flowing into assets that deliver steady income. 

The boom in Self-Managed Superannuation Funds (SMSFs) has also fuelled interest in income investing. SMSFs hold about a quarter of Australia’s superannuation pool.[13] Anecdotally, many SMSF trustees prefer to invest directly in higher-yielding assets through ASX. 

Australia has a good record in income investing. Dividend payments from ASX-listed companies, on average, are high by international standards.[14]

Australia’s success in income investing is partly because of tax policies, principally our system of dividend imputation (franking credits) that began in July 1987.

Previously, earnings were taxed at the company rate and personal tax rate for shareholders. Dividend imputation means company profits paid to shareholders are taxed only once. 

On average, about 65 per cent of ASX-listed company earnings were paid to investors from 1917 to 2019, according to Reserve Bank research.[15] Although it fluctuates, Australia’s dividend payout ratio has risen since the introduction of dividend imputation.

Income-investing challenges

Of course, a higher average dividend yield from ASX-listed companies is no guarantee of income-investing success. As in other markets, some ASX-listed companies cut, cancelled or deferred their dividend during market crises, such as the GFC and the Covid pandemic. 

Dividends paid by ASX-listed companies, on average, grew substantially after the GFC, most notably among banks and resource stocks.[16] RBA research identified a reluctance among ASX-listed companies to cut dividends when profit growth weakens.[17]

In the latest ASX Australian Investor Study, investors at all life stages said they will focus more on the sustainability of future dividends after Covid.[18] SMSF trustees nominated dividend sustainability as their top priority after the pandemic.[19]

Asset allocation in a low interest-rate environment is another consideration. A portfolio comprising 60 per cent shares and 40 per cent bonds – once considered a mainstay of income investing – may no longer provide sufficient returns for many retirees. 

If rates stay near zero for some time, more investors might increase their allocation to growth assets (such as shares) to boost yield, and slightly reduce their exposure to defensive assets. They should seek financial advice before doing so.

Here is a snapshot of developments in ASX’s modern history that are giving income investors more choices, and greater scope to diversify their portfolio at lower cost.
 

1. ASX-listed companies

The Australian sharemarket’s sector composition provides much choice for income investors seeking partially or fully franked dividend yield. 

The S&P/ASX 200 Index has a 30 per cent weighting in Financials.[20] In many income portfolios, some or all of the big-four bank stocks are a core holding because of their yield.

Materials is the second-largest sector in the ASX 200 Index by weighting (20 per cent). Many resource companies, particularly those in the exploration phase, do not pay dividends because they are re-investing earnings to grow their business. 

Resource stocks, in aggregate, have had volatile dividend payout ratios over the years.[21] Dividend payout ratios in the mining sector tend to fall during the investment phase of a resource boom (when earnings are being reinvested), and rise during the production phase.[22]

Rising iron-ore prices in the past two years have increased the appeal of large mining stocks for income investors.[23] BHP Group (ASX: BHP), Rio Tinto (RIO) and Fortescue Metals Group (ASX: FMG) had trailing dividend yields that significantly higher than those of the big-four bank stocks at July 2021[24], such has been the effect of higher iron-ore prices on earnings and dividends. Whether higher yields in the resource sector will last depends greatly on commodity prices. 

Together, the Financial and Materials sectors – parts of which currently appeal to income investors – account for half the S&P/ASX 200 Index.[25]

Another sector favoured by income investors – Australian Real Estate Investment Trusts (A-REITs) – has an almost 7 per cent weighting in the ASX 200.[26] Celebrating its 50th anniversary on ASX this year, the A-REIT sector is one of the world’s great REIT markets. 

Over the years, A-REITs have been popular with income investors who want exposure to trusts that own high-quality buildings with tenants on long leases. In theory, the income from these leases should be less volatile than company earnings, although that is not always the case.

Infrastructure is another sector that suits income investors who want exposure to monopoly-like assets, such as airports or toll roads. Or to assets, such as electricity generators or gas pipelines, with reliable, inflation-linked revenue. 

There were seven ASX-listed infrastructure funds worth $82 billion at end-June 2021.[27]

The S&P/ASX 200 also has a high weighting in retail stocks. The Consumer Discretionary and Consumer Staples sectors together account for 13 per cent of the index. Some income investors hold supermarket and retail conglomerates for their defensive qualities and yield.

Initial Public Offerings (IPOs) on ASX have added new choices for income investors. Some of the largest IPOs since 1998 have been for established, dividend-paying companies. 

These include floats of Medibank Private in 2014 (ASX: MPL) and Spark Infrastructure Group (ASX: SKI) and AusNet Services (ASX: AST) in 2005. The New Zealand renewable-energy utilities, Meridian Energy (ASX: MEZ) and Mercury NZ (ASX: MCY), dual listed on ASX in 2013.

2. Fixed income

Australian retail investors have long had an underweight position in fixed interest. Respondents to the latest ASX Australian Investor Study said their portfolio, on average, had only 1 per cent of its assets in government and corporate bonds.[28]

A balanced portfolio might hold 40 per cent in bonds and cash, depending on an investor’s age, risk tolerance and investment needs. An older income investor might have an even higher allocation to defensive assets.

Although bonds return less than shares over time[29], fixed interest has an important diversification and risk-mitigation role in portfolios. For older investors who have less scope to recover from sharemarket falls, bonds have been a portfolio mainstay.

Poor accessibility partly explains the low use of bonds by Australian income investors, compared to those in the United States. Most bonds are traded in secondary “over the counter” (OTC) markets rather than on listed exchanges. Bonds can be harder for income investors to buy in OTC markets, or require a larger minimum investment.

Recognising this problem, ASX implemented several fixed-interest initiatives in its modern history. In 2011, ASX launched a comprehensive package for benchmarking tools for fixed-interest investments in Australia: the S&P/ASX Australian Fixed Income Series. That allowed investors to track returns from a basket of fixed-income securities.

In May 2013, ASX announced that Exchange Traded Australian Government Bonds (AGBs) would be available, giving retail investors access to buy and sell these bonds as easily as shares. 

There are two types of AGBs on ASX: Exchange Traded Treasury bonds and Exchange Traded Treasury Indexed Bonds (which are adjusted for changes in the Consumer Price Index).

In May 2015, XTB, a private company, launched the first XTBs on ASX. XTBs are financial products that provide easy access to the returns of individual corporate bonds.[30] In doing so, they open up an asset class that has been hard for Australian retail investors to reach.

The ASX Hybrid market is another option for income investors. A hybrid security combines elements of bonds and shares. Hybrids typically promise to pay a fixed or floating rate of return until a certain date, in the same way a bond does. However, hybrids can also have share-like features, meaning they might provide a higher return than bonds, and have higher risk.

The total ASX Hybrid market, which includes convertible preference shares and capital notes, convertible bonds, and hybrids, had a combined market capitalisation of $43.7 billion at end-June 2021.[31] There were 53 hybrids on ASX, several issued by Australia’s largest banks.

This combination of hybrids, government and corporate bonds has made it easier for income investors to access fixed-interest assets to portfolios, via ASX. 

3. Listed funds/companies/trusts

Growth in ASX-listed or unlisted funds that invest in higher-yielding shares, or government and corporate bonds (here and overseas) has also supported income investors.

In 2010, Russell Investments launched the Russell High Dividend Australian Shares ETF (ASX: RDV). This Exchange Traded Fund tracks an index of ASX-listed companies that have a higher expected dividend yield and history of reliable dividends. Several other ETFs issuers launched yield ETFs that aim to enhance income from Australian shares. 

In 2012, fixed-interest ETFs were launched on ASX. For the first time, income investors could use a fixed-interest ETF for exposure to Australian government bonds. This meant income investors could buy and sell a portfolio of bonds on ASX in a single trade, just as they would shares.

Later that decade, ETFs were launched over investment-grade corporate bonds and subordinated debt in Australia, and global corporate bonds in developed and emerging markets. There were 35 fixed-income ETFs on ASX, worth $14.3 billion, at end-June 2021.[32]

The BetaShares Australian High Interest Cash ETF (ASX: AAA) was launched in 2012. This meant income investors could use ASX to fulfil the cash allocation in their portfolio, rather than lock funds away in bank term deposits (and have less liquidity). AAA provides exposure to cash deposits and has monthly income distribution. 

Other cash ETFs include the iShares Core Cash ETF (ASX: BILL) and the iShares Enhanced Cash ETF (ASX: ISEC). Both were launched in June 2017.

Hybrid ETFs were another important development. These ETFs provide access to a diversified portfolio of hybrids and are bought and sold like a share on ASX. Hybrid diversification is important for conservative income investors given the risks of hybrids compared to bonds. 

In November 2017, the BetaShares Active Australian Hybrids ETF was launched (ASX: HBRD). In April 2021, the BetaShares Australian Major Bank Hybrids ETF (ASX: BHYB) launched on ASX, giving income investors access to a portfolio of hybrids issued by big banks.

Listed Investment Companies (LICs) and Listed Investment Trusts (LITs) on ASX are another option for income investors. LICs and LITs provide exposure to an actively managed basket of securities, such as Australian or global shares, or fixed income. 

The company structure of LICs (investors buy and sell shares in the LIC, not units in its underlying fund) allows them to retain earnings and potentially smooth the flow of dividends each year, or improve their capacity to pay future dividends. 

By contrast, LITs must distribute all net income and released capital gains on a pre-tax basis (because they are trusts) to investors. 

LICs have a proud history on ASX. The market’s largest LIC, Australian Foundation Investment Company (ASX: AFI), listed on ASX in 1928.

There were 102 LICs and LITs, worth a combined $58 billion, on ASX at end-June 2021.[33] Many LICs target income investors and some pay quarterly dividends.

Fixed-income LITs have been a new development on ASX in recent years. The MCP Master Income Trust (ASX: MXT) listed on ASX in October 2017. MCP invests in Australian corporate loans and targets income investors. Other LITs invest in real estate loans, local and overseas private credit, or corporate debt – and aim to deliver reliable yield to investors.
 

4. mFund

ASX’s launch of mFund in 2014 has provided further choice for income investors. mFund enables investors to access unlisted managed funds through their broker, without having to complete lengthy paper-based applications or wait days for orders to be processed. 

ASX believed mFund would help retail investors, SMSF trustees and financial advisers access additional asset classes, such as fixed income, not readily available on ASX at the time.

Today, 240 mFunds have a combined market capitalisation of $1.74 billion[34]. Many leading asset managers are foundation members of mFund. Together, they offer unlisted managed funds across a range of asset classes in Australia and overseas. 

mFund had 43 fixed-income funds available in July 2021.[35] These funds mostly hold Australian or global bonds, or diversified credit – and are designed for income investors.

Income investors can also use mFund to invest in equity income unlisted managed funds, such as the Plato Australian Shares Income A Fund. Or invest in a range of unlisted property and infrastructure funds that hold Australian or global assets.