It just doesn’t seem long ago that economists from the big banks were predicting a round of interest rate rises.
Go back six months and most of the commentary was about when, not if, these rate rises would happen.
Roll forward six months, and it’s a different story. During their monthly meeting on Tuesday, February 3rd, the Reserve Bank of Australia (RBA) Board decided to lower the official cash rate from 2.5% to 2.25%. That was the first move in 18 months.
Of course, home owners with a variable rate mortgage will be happy with the RBA’s cut. A borrower will save around $15 per month for every $100,000 borrowed. So a borrower with a $400,000 loan will save around $60 per month (or $14 per week) on a typical 30 year variable rate mortgage.
That’s good news. The not so good news is that for another group of people it will just add more pressure as they search for income from their investments. I’m talking about savers. To make matters worse, no sooner had the Reserve Bank of Australia cut rates, than there was an instant debate about whether they will cut again in March.
Although this 0.25% reduction might not seem like a lot on the surface, it effectively means a 10% drop in earnings if you’re holding cash in a term deposit or savings account. Add this up over a number of rate cuts, and it becomes increasingly harder if you’re relying on this income to meet your financial commitments and to maintain your standard of living.
Unfortunately, the trend doesn’t look like reversing any time soon. Central Banks around the world have recently been lowering rates as they attempt to boost their struggling economies. At last count, 15 central banks have lowered their cash rates this year alone…and it’s still February!
Here in Australia, you would have to look hard to find an economist predicting an interest rate rise any time soon. That means low and perhaps even lower interest rates for some time to come.
To overcome this, investors need to look at different ways to give their income a pick-me-up. One solution is to look at one of the best (and potentially tax effective) ways of generating extra income.
I’m talking about dividends. But how do you go about it?
Wouldn’t you like income without the work?
When companies make a profit and want to share this amongst their shareholders, they announce a date at which this distribution will occur. Shareholders registered at the record date are entitled to a share of the company’s profits. This is a dividend.
Most blue chip companies on the ASX pay out two dividends a year — an interim, and a final dividend.
Typically, the more a company pays out in dividends, the more investors are prepared to pay for shares in that company. But there is more to it than that. Just because a company pays out a high dividend, doesn’t necessarily mean that it will continue to do so.
One way you can check is to look at what a company has done in the past. Blue chip companies keep their dividend history on their website…some information will go back ten or fifteen years. Here you can see the size of past dividends, and how often they have paid them.
Some companies also publish a payout ratio. In effect, this sets out the company’s policy on the percentage of company profits that it will pay to their shareholders. Commonwealth Bank, as an example, currently pays out 75% of profits to its shareholders.
Another important thing to consider is dividend stability. As the name implies, this highlights the company’s ability to pay regular and consistent dividends to their shareholders over a period of time.
After all, if you’re relying on dividends for income, you want to be pretty sure how much you’ll get…and when.
Look out for ‘phantom’ dividends
However, one trap investors can fall into, is to focus solely on the size of the most recent dividend, and the dividend yield. (The yield refers to the amount a company pays out in dividends per year as a percentage of the current share price.)
But a lot can happen over 12 months. A company that was profitable last year might not be doing as well this year and might need to preserve its cash. To do this, it may reduce or even cut its dividend entirely.
Also, the share price might have fallen over the last 12 months, which may artificially inflate the dividend yield. So even though the data may say the company has a 25% yield, the reality is almost always different. That’s why I call those ‘phantom’ dividends — they aren’t real.
As a potential investor, you also need to analyse the prospects of the company and the sector in which it operates. And you need to look at the overall economy, as well as the stock market as a whole to gauge which direction you think it will move.
It’s not just a matter of searching out the highest yielding stocks and leaving it at that. You’re still risking your investment money whenever you buy shares in a company. So you need to monitor your investments and react accordingly.
How to give your income a major boost
Whilst it’s important to be conservative with a core portfolio of dividend paying stocks, one way to help bolster income further is to look outside the top ASX 20 or ASX 50 stocks. There are some 2,000 or so listed companies on the ASX, and many of them pay dividends.
Not only do many of them pay a good dividend now, but they have a good record of increasing dividends too. That’s the benefit of investing in small, but growing companies.
The mainstream press and advisory firms don’t cover a lot of these other stocks. But there are plenty of opportunities if you’re diligent and do your research.
Income Specialist, The Daily Reckoning Australia
Editor’s Note: This article originally appeared in Money Morning.