INSIGHTS

WHEN SAFE STOCKS BECOME HIGH RISK

Mark Lister, 12 September 2016

Unsurprisingly, record low interest rates have created an insatiable demand for anything that provides an above average income stream, or “yield”. This includes much of the New Zealand sharemarket, given the dominance of utilities, infrastructure and real estate companies on the NZX.

With investors willing to pay ever increasing prices for these attractive yields, the low risk, safer companies have started to become unsafe and higher risk by virtue of the prices they are trading at.

The six-month term deposit rate is 3.2 per cent, well down from the fantastic rate of 8.5 per cent investors were getting in 2008. Back then, it took a retirement nest egg of $710,000 to provide a before tax income of $60,000 a year. At 2016 interest rates, it takes a whopping $1.9m. You can almost buy a decent Auckland house for that sort of money.

It’s easy to see why investors have flocked to shares, given the average pre-tax dividend yield of about five per cent in New Zealand. Some pay even higher dividends, with the listed property sector offering about 6.5 per cent and the electricity companies providing more than 8.0 per cent per annum.

Who needs fixed interest when you can get that in the sharemarket? With a bit of luck, interest rates will keep falling, making the dividend yields from these even more attractive and pushing the share prices up further.

But it could all come unstuck. If interest rates reached their trough, and began to rise again, these high-yielding shares would quickly fall out of favour with many investors. The dividends may well be rock solid, but their share prices could easily fall.

If the market decided 6.0 per cent was no longer a good enough yield for a company, and that it now needed to be 7.5 per cent, the share price would have to fall 20 per cent. Sounds ominous, but it could happen if interest rates went back to more normal levels.

That’s probably not likely over the next year or two, but I wouldn’t count on interest rates being at rock bottom forever. The US is talking more loudly about interest rate hikes, which would flow through to us down here. Our currency would fall, pushing imported inflation higher and reducing the need for the OCR to be so low.

Selling all of the companies in these high yield sectors isn’t the answer. Many of these are excellent investments that will provide attractive, growing income streams in years to come.

However, investors who have loaded up on them to fill the fixed interest gap are at risk, should the winds change. While they’ve been flavour of the month for some time now, that might not always be the case.

When interest rates are rising, it tends to be the growth shares that do better, rather than the higher yielding ones. I would be making sure I had a healthy weighting to the former, as well as the latter.