Most of the discussion on Labor’s proposed changes to franking credits has focused on how retirees and investors in SMSF pension phase might experience a significant fall in their (after-tax return) income.
Little has been written about the impact on bonds and hybrids and the solution they may provide. It is also a timely reminder to assess regularly the asset allocation and balance of investment portfolios. The current environment provides a unique opportunity to potentially decrease risk and increase overall return with a reallocation between cash, bonds and equities.
Currently, individuals and superannuation funds are entitled to a refund of franking credits if the franking credits plus any PAYG tax paid by the individual or fund exceeds their tax liability. Under Labor’s proposal, with some exceptions such as the ‘pensioner guarantee’, refunds that exceed tax liabilities will no longer be available for most taxpayers.
Potential loss of income
The practical implication is that retirees and in particular SMSFs in pension phase are most at risk of losing significant franking credit cash refunds. This can reduce after-tax dividend income by up to 30%.
For example, an SMSF in pension phase (hence 0% tax rate) with a share portfolio of $1.5 million earning a dividend yield of 6.0% plus franking would currently be entitled to a refund of $38,571.43. Under the Labor proposal, this entire refund could be lost for some investors.
$1.5 million x 6.0%/(1-30% tax rate)
= $1.5 million x 8.57% fully franked dividend
= $128,571.42 of which $90,000 is received in cash and $38,571.43 in franking credits.
How hybrids are different
The same SMSF with $1.5 million in franked hybrids paying 6.0% (inclusive of franking), as opposed to dividend paying shares, would have lower overall income and franking refund component.
This is because the market quotes share dividends as a yield before franking whereas hybrids are quoted inclusive of franking. A 6% dividend on say a bank share is actually 8.57% (or 42.9% higher) when franking is added. A 6% fully franked hybrid pays $63,000 in cash income and $27,000 in franking credits. The latter is at risk of being lost to some investors.
$1.5 million x 6.0% (inclusive of 30% franking credits)
= $90,000 fully franked distribution, of which $63,000 in cash i.e. 6% x (1-30% tax rate) and the balance of $27,000 i.e. 6% x 30% tax rate in franking credits.
The role of bonds and hybrids in limiting the impact
Individual circumstances vary, including the entities and tax structures available, and other articles in Cuffelinks have described alternatives to reduce the impact of a loss of franking. See, for example, Steps SMSFs may take to beat Labor’s franking, On franking, all public funds are not the same, Labor franking policy will change behaviour, and How SMSFs can utilise franking credits under Labor .
There are also a number of strategies specific to bonds and hybrids which have received little commentary. In particular, bonds and hybrids can provide effective solutions for those who need to maintain high income levels. Options include investing in:
A high-income bond portfolio. Bonds do not have any franking credits and a relatively conservative bond portfolio can be tailored with returns of 6-7% p.a. For investors comfortable with sub-investment grade bonds, the ability to construct a high-yielding portfolio of 7%-plus is possible as there are a number of bonds with returns in the high single digits including 6-12-month senior secured property bonds with low Loan to Valuation Ratios around 50%. A number of foreign currency bonds also come with high running yields such as the Citigroup USD 3mth Libor+6.37% and the NCIG 12.5% USD bond (but these also carry currency risk).
Indexed annuity bonds which pay down principal and interest over their life. These are typically issued by very high-quality A, AA and AAA rated government or public private partnership (PPP) entities and are also indexed to inflation, providing excellent protection. The downside is that at the end of the term the capital value has been completely exhausted but they are a good vehicle for those looking to enhance the cash return received each quarter
Hybrids that pay no or minimal franking credits. Two of our favoured AUD investments across the bond and hybrid market are the ASX listed National Income Securities (ASX:NABHA) and Macquarie Income Securities (ASX:MBLHB). These legacy Tier 1 hybrids were issued in 1999 and neither has any franking attached to their distributions. We expect both of these securities to be redeemed for $100 before 2022. While the running yields are 3.6% and 3.8% respectively, with the current prices in the high $80s, yields to call of over 10% are expected, adding to the consistent 10-15% annual return each has provided since early 2016. Repeating, none of the return includes a franking component. A number of ‘new style’ Basel III-compliant hybrids are also available with minimal or partial franking credits including those issued by AMP and Macquarie Bank.
Over the years we have often written that we do not subscribe to the view that ‘all hybrids are bad’. Rather we suggest investors consider the specific risk and return parameters of each security (including the impact of franking credits). At present, we still see value in legacy hybrids with no franking credits but generally believe new style hybrids are a touch expensive given the risk of a possible sell-off following a Labor election win. However, should credit margins on new style hybrids approach +5% again, we would most likely see value outweighing those risks.
An opportunity to review portfolios
The Labor franking policy provides an opportunity for investors to consider not only their tax position but also their overall investment portfolio balance. As a general rule, most Australians (and in particular SMSFs) are over-exposed to property, equities and cash. On the flip side, we have one of the lowest exposures to bonds of all OECD countries. Direct investment in bonds (as opposed to via a managed fund) is less than 1% across the SMSF sector.
With cash rates at 1.5% and market predictions of further RBA cuts, term deposit rates are likely to have a ‘1’ handle for some time. After factoring in inflation, many cash positions generate a negative real return. Large cash positions represent a drag on portfolios that can be replaced with a variety of bonds yielding 3.5-6.0%. If Labor’s franking policy is enacted, investors could reduce risk and volatility and maintain or even increase (after-tax return) income by re-assessing their allocation to bonds and select hybrids.
Justin McCarthy is Head of Research at BGC Fixed Income Solutions Australia, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual. Investors should consider their risk appetite and product knowledge and seek financial advice before taking action.
For other articles by BGC Fixed Income Solutions, see here.