How to Beat the Latest Interest Rate Cut

Girl counting Australian money
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If you’re somebody relying on your savings to help fund your retirement, you don’t need anyone to tell you the impact of the latest interest rate cut. You know that already.

Those with a mortgage will always welcome any rate cut. That’s a given. However, for all those on the other side of the fence — the depositors funding the banks’ lending — every cut makes it harder to make ends meet. But don’t expect sympathy any time soon.

In Commonwealth Bank’s [ASX:CBA] update on Monday (9 May), the bank confirmed that 64% of its funding now comes from its depositor base. It’s only because this type of funding is increasing that CBA, and other banks, have been able to maintain their margins — or in bank speak, their net interest margin (NIM).

NIM is the difference between the interest paid on a bank’s funding, versus the interest received from their lending activities. Funding includes everything from kids’ bank accounts, term deposits, and right through to both short and long term debt facilities. Lending is as you’d think — it’s the bank’s total loan book, with everything from car and personal loans, through to home and business loans.

With the latest cut taking the official cash rate to 1.75%, it’s hard to believe that this rate was 7.25% heading into the GFC. Taking a current rate from one of the Big Four as an example, if you put $100,000 in a term deposit for six months, you’d earn around $44 a week.

Even if you locked the same amount of funds up for five years, you’d still only get around $52 a week at present. Although, of course, you’ll likely only receive that interest at the end of the term, or at the end of each year.

Looking at it another way, if you can cut $44 a week from your outgoings, that’s the equivalent of having $100,000 invested in a term deposit. No wonder so many have gone into the share market as the cash rate continued to fall.

But, of course, while there are higher yields to be gained in the market, it comes with extra layers of risk. Anyone who bought into Woolworths [ASX:WOW] a year or so ago based on its dividend yield, for example, is sitting on a capital loss of around 25%. Go back another 12 months, and the share price has nearly halved.

ETFs and managed funds are one way to diversify your risk away from owning individual shares. It lessens the possibility of one stock putting a big hole in your portfolio. And while these funds can be passive — only replicating an index, for example— there are others that are active, specialising in specific parts of the market, such as emerging markets, US and European shares, and commodities like oil and gold.

With interest rates at such low levels, that has facilitated the rise and popularity of another type of fund — income ETFs. These are funds that focus on generating income, where capital gains, although welcome, is less of a goal.

While the basic goal of the various income ETFs is the same, it’s how they go about it that differs. For example, (please note that any ETF mentioned here is for the purposes of illustration, and is not a specific recommendation), State Street Global Advisers (through their SPDR funds) has the Australian Select High Dividend Yield Index Fund [ASX:SYI].

The $800 million market-cap SYI uses basic fundamental data to choose its investments — things like earnings per share (EPS) growth on a three to five year basis. It also uses thresholds of price/earnings ratios, cash flow analysis, returns on equity and dividend yields to determine its portfolio.

Look through its near 40 constituents, and you’ll see most of the ASX 20, including the banks, Woolworths and Telstra [ASX:TLS], and stocks like Amcor [ASX:AMC] and Insurance Australia Group [ASX:IAG].

For someone looking to gain access to these biggest companies on the ASX, along with regular dividends (SYI pays out its distributions quarterly), this allows them to gain this exposure and income through the one holding.

BlackRock offers a similar product — the iShares S&P/ASX Dividend Opportunities ETF [ASX:IHD] — which also targets the largest stocks on the ASX. Look at its constituents and you’ll soon see a similar holding to SYI. It currently trades on a 6.3% yield, and also pays its distributions quarterly.

It’s a pretty competitive field, with Vanguard also offering the Australian Shares High Yield ETF [ASX:VHY], although it doesn’t hold any of the REITs, and Russell’s High Dividend Australian Shares ETF [ASX:RDV], which includes REITs, plus insurance companies and regional banks like Suncorp [ASX:SUN], and Bendigo and Adelaide Bank [ASX:BEN].

More recently, the list of income focused ETFs has grown to include active funds, like BetaShares’ Australian Dividend Harvester Fund [ASX:HVST]. While those mentioned above use a ‘buy and hold’ type approach, HVST uses a rotational strategy to buy into stocks about to pay a dividend, selling them after the dividend has been paid.

There are holding rules that apply for franking credits but, typically, HVST rebalances its portfolio every two months to get ready for the next lot of dividend-paying stocks. While HVST currently trades on a higher yield than other income ETFs, its share price has performed less well compared to the others.

With no one expecting a rise in our official cash rate any time soon, you can expect to see the popularity in income based ETFs rise. If these type of ETFs do appeal, take some time to check out their investment strategy, and the shares they hold, before looking to invest your funds.

As management fees can put a real dent in total returns, make sure you check out the fees quoted by the ETF providers. While some, like Vanguard, have a flat fee, some have both management and performance fees, which can be several times more expensive.

And always understand the product. Despite paying a regular income, the value of ETFs will still fall if the underlying shares they hold fall in value. So think of it as holding a portfolio of stocks, through just the one holding.

Matt Hibbard,

For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.
Matt Hibbard

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