Sydney Wealth Management Update Summer 2019

By Martin Fowler - December 11, 2019

Welcome to our Sydney Wealth Management team’s 2019 Summer Wealth Management Update. This edition covers the following topics: Super strategies, applying the unused concessional contribution caps, understanding bonds and an introduction to ethical investing.

Super strategies: Unused concessional contribution caps

What are concessional contributions?

Concessional contributions into superannuation obtain special tax treatment by virtue of being taxed at a concessional rate[1]. In practice, this means most taxpayers pay less tax on their superannuation contributions than they otherwise would on their income (where their marginal tax rate is greater than 15%). Concessional contributions include:

  • Employer contributions, either as Superannuation Guarantee (SG) payments or contributions made under a salary sacrifice arrangement,
  • Personal contributions claimed as a tax deduction.

If an individual has more than one superannuation fund, all concessional contributions made to all their funds are counted towards the concessional contributions cap (CC cap). The current CC cap is $25,000.

Unused CC cap carry forward rule

If an individual has a Total Superannuation Balance (TSB) of less than $500,000 as at 30 June of the previous financial year, the carry forward rule allows that individual to contribute more than the general CC cap by making additional concessional contributions for any unused CC cap amounts. Prior to this amendment, the “use it or lose it” motto applied and if individuals did not utilise their CC cap in a given financial year, they could not carry forward the unused cap to a later year.

As the carry forward rule start date was 1 July 2018, the first year individuals will be entitled to use the carry forward unused amounts is the 2019/20 financial year. If concessional contributions in a year are lower than the annual cap, the “unused” amount can be accumulated and carried forward over a rolling five-year period. An example of how unused CC caps are carried forward in practice is outlined in Table 1. 

Table 1: Example of unused CC cap carry forward

Description

2018/19

2019/20

2020/21

2021/22

2022/23

2023/24

General CC cap

$25,000

$25,000

$25,000

$25,000

$25,000

$25,000

Total unused CC cap accrued

$0

$22,000

$32,000

$47,000

$72,000

$22,000

Maximum CC cap available

$25,000

$47,000

$57,000

$72,000

$97,000

$25,000[2]

Superannuation balance 30 June prior year

$380,000

$440,000

$455,000

$470,000

$495,000

$595,000

Concessional contributions

$3,000

$15,000

$10,000

$0

$75,000

$20,000

Cumulative available CC cap

$22,000

$32,000

$47,000

$72,000

$22,000

$27,000[3]

Technically, a situation might arise where an individual could contribute up to $150,000 in a single financial year by utilising unused CC caps from the previous five financial years. Note that work test rules still apply for people aged 65 and over in order for a fund to accept concessional contributions and the usual notice requirement continues to apply for personal deductible contributions. Furthermore, if the extra contributions lead to the TSB exceeding the $500,000 threshold, no further unused concessional contribution amounts may be made in future years unless the TSB falls below $500,000 again. The unused CC cap carry forward option may be particularly useful for individuals returning to the workforce after an extended period of leave or for those who have sold an asset and have realised capital gains they would like to offset.

Understanding bonds

What are bonds?

  • Bonds are simply loans whereby a borrower is obligated to pay the holder of the bond a specified sum of money at regular intervals and to repay the face value of the bond (the principal) at a given future date (the maturity date).
  • The interest rate paid by the borrower is normally fixed when the bond is issued.
  • Owners of bonds are also called creditors or debtholders.
  • Issuers of bonds are usually governments or corporations. 
  • Other names for bonds are “fixed interest” or “fixed income” securities.

Types of bonds

  • Bonds vary according to several characteristics, namely the:
    • Issuer;
    • Time until maturity;
    • Interest rate, and
    • Risk.
  • The safest bonds are typically government bonds issued by a country with a strong credit rating, but they also pay the least interest. Longer-term government bonds usually pay marginally higher yields than short-term bonds to compensate for the duration risk.
  • Corporate bonds are issued by companies. They have more risk than government bonds because corporations cannot raise taxes to pay for the bonds and therefore may default on their obligations.
  • The risk and return of a bond depends on the credit-worthiness of the company.
  • The highest paying, and therefore, riskiest bonds are called junk bonds.
  • Bonds and corporations rated BB and lower (by Standard and Poor’s) are speculative and these entities have a higher Probability of Default.

The inverse relationship between bond prices and bond yields

  • Bond yields move inversely with bond prices. In other words, the more demand there is for bonds, the lower the yield since the interest payment is fixed and the higher demand leads to an increase in the bond price.
  • Demand for bonds usually increases when the business cycle is contracting, the economic outlook is uncertain or bleak or the economy is slowing significantly or in recession.

The fluctuations in bond prices

  • Once issued, bonds can be traded in the secondary market or sold privately between a broker and the creditor.
  • Bonds are issued initially at par value (also known as the face value), or $100.
  • Since bonds can be resold, the value of the bond rises and falls in response to the supply and demand of the bond.
  • The most influential factors that affect a bond's price are:
    • Yield;
    • Duration;
    • Prevailing interest rates; and
    • The bond's credit rating.
  • When a bond reaches its maturity, the holder will receive the face value of the bond.

The concept of duration and its relationship to interest rates

  • Duration is a measure used to gauge a bond’s interest rate sensitivity. Expressed in years, duration indicates how the bond’s price changes for each percentage point change in interest rates.
  • For example, when interest rates fall by 1%, the price of a bond whose average duration is 4 years will rise by 4%. Conversely, if interest rates rise by 1%, the same bond’s market price will fall by 4%.
  • The greater the duration, the greater the bond’s sensitivity to interest rate changes.

A bond’s duration is affected by two factors:

  • Time to maturity: The amount of time, in years, before a bond matures. The bond that matures in one year would repay its true cost sooner than a bond that matures in ten years. Therefore, all other factors being equal, bonds with shorter maturities would have a lower duration and lower interest rate risk.
  • Coupon rate: The interest rate that a bond pays to the bondholder. If two identical bonds pay different coupons, the bond with the higher coupon will pay back its principal earlier than the lower yielding bond. Therefore, all other factors being equal, the higher the coupon the lower the duration.

Running yield and yield to maturity (YTM)

  • A bond’s running yield (also known as the current yield) is the interest that a bond produces (coupon), as a percentage of the bond’s current price. The running yield varies as the bond price fluctuates.
  • A bond’s yield to maturity (YTM) is the rate of return on a bond if the bond is held until its maturity date.
  • YTM is different from the running yield as it expresses the total return of a bond rather than its interest component only.
  • YTM is higher than the coupon rate if the bond currently trades at a discount due to the extra return generated when the bond receives its face value at maturity. The reverse is true when a bond is priced at a premium.

The yield curve

  • The yield curve is a graph of bond yields at various terms to maturities. The graph is plotted with interest rates on the y-axis and increasing time durations on the x-axis.
  • Since short-term bonds usually have lower yields than longer-term bonds, the yield curve normally slopes upwards. This “term structure” of interest rates is referred to as a normal yield curve. For example, the coupon of a one-year bond is lower than the coupon of a 10-year bond during times of economic growth.
  • When the term structure shows an inverted yield curve, short-term yields are higher than longer-term yields, which implies that investors’ confidence in economic growth is low. Historically, such an inverted yield curve has been a precursor to recession in the next 12-18 months. An example of a normal, a flat and an inverted yield curve is shown in Figure 1.

Figure 1: Normal, Flat and Inverted Yield Curves

Source: medium.com

 

Credit ratings and the Probability of Default

  • A credit rating is an assessment of a borrower's (normally a government or corporate entity) credit worthiness, that is, their ability to repay a debt or their likelihood of defaulting. The scale of credit ratings (i.e. investment grades) of various credit agencies are shown in Table 2.
  • The Probability of Default is the probability of a borrower defaulting on loan repayments and is used to calculate the expected loss from an investment.
  • The lower the bond’s credit rating, the higher the Probability of Default. The cumulative Probability of Default across various tenors and investment grades for global corporates is shown in Table 3. For example, a B-rated corporate has a 1-year Probability of Default of 3.44% and a cumulative 5-year Probability of Default of 17.33%.

 

Table 2: Scale of credit ratings of various rating’s agencies

Source: Standard and Poor’s, Moody’s and Fitch ratings agencies

 

Table 3: Global corporate average cumulative default rates (1981-2019)

 

An introduction to ethical investing

What is ethical investing?

According to the Cambridge English dictionary, ethical investing ‘is the practice of investing in companies whose business is not considered harmful to society or the environment’. It is also known as responsible investing or sustainable investing.

Ethical investing has expanded beyond this definition to include sustainability, governance, business practices, and community involvement, all of which may be considered alongside financial performance when making an investment decision.

In recent years the sector’s growth rate has been astonishing. According  to a recent report from the Responsible Investment Association Australasia (RIAA), 44% of the $2.24 trillion managed by professional investors in Australia was invested using an ethical investment strategy. In 2013 only 17% of funds were directed into responsible investments. According to the Global Sustainable Investment Alliance (GSIA) global responsible investment assets  as at the end of 2017 exceeded US$30 trillion.

Types of strategies

As the responsible investment sector continues to rapidly evolve, a bewildering array of terminology has emerged, which can make it confusing for the average investor to understand when reviewing product disclosure statements. To simplify, a summary of the main strategies, as recognised by the RIAA, are as follows: 

  • ESG integration

ESG integration involves the consideration of environmental, social and governance factors into the investment decision-making process.

  • Corporate engagement and shareholder action

Corporate engagement and shareholder action refers to shareholders exercising their influence to persuade boards and senior management to initiate change, through a range of measures including proxy votes and submissions, to better align corporate activities with ESG guidelines.

  • Negative/exclusionary screening

Negative/exclusionary screening is where an investment mandate specifically prohibits investments into certain sectors or companies on ethical grounds. Weapons and tobacco manufacturers are the most common among Australian institutional investors.

  • Norms-based screening

Norms-based screening involves the screening of investments that do not meet minimum standards of business practice. This might include companies being screened out for contravention of labour laws, the Modern Slavery Act or international conventions sanctioned by the United Nations, such as the Paris Agreement.

  • Positive/best-in-class screening

Positive screening is the inclusion of companies or sectors in a portfolio that rate highly in terms of ethical, environmental, social and governance factors.

  • Sustainability-themed investing

Sustainability-themed investing relates to the inclusion of investments that are environmentally or socially sustainable. Examples include clean energy, sustainable forestry, and water technology.

  • Impact investing and community investing

Impact investing targets financing specific projects that help resolve social or environmental issues. Examples include affordable housing, healthcare or renewable energy.

Do ethical funds outperform?

It is often thought that ethical investments, where the paramount consideration is not financial gain, could produce sub-optimal investment returns. Over the years there have been a number of conflicting studies where results have been mixed. A study completed recently by the RIAA, however, suggests that they have outperformed over the time periods measured. The study showed that Australian equities responsible share funds returned on average 6.43% over five years and 12.39% over 10 years. That compared with returns of 5.6% and 8.91% respectively for the S&P/ASX 300 index.

Our view on ethical investing

We understand every client has different ethical views and preferences. Our goal is to not impose any personal views but to work with clients to develop and tailor an investment portfolio that best suits their individual goals, objectives and ethical preferences. Do not hesitate to contact your Pitcher Partners adviser to discuss further.

 

Disclaimer
Liability limited by a scheme approved under Professional Standards Legislation. Any advice included in this newsletter has been prepared without taking into account your objectives, financial situations or needs. Before acting on the advice you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs. You should also obtain a copy of and consider the Product Disclosure Statement for any financial product mentioned before making any decisions. Past performance is not a reliable indicator of future performance. Advisors at Pitcher Partner Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth management Pty Ltd, ABN 85 135 817 766, AFS and Credit Licence number 336950.

[1] Concessional contributions are taxed at 15% when they enter the super fund, unless the individual’s adjusted taxable income is over $250,000 (including concessional contributions). In the case of the latter, the effective tax rate is 30%.  
[2] Maximum CC cap available is $25,000 as the TSB as at 30 June 2023 (i.e. 30 June of the previous financial year) exceeded $500,000.
[3] This amount is only available if the TSB is less than $500,000 in a future year. Notwithstanding the CC cap carry forward rule, personal concessional contributions cannot create a tax loss for individuals. In this context, some planning might be required in order to utilise amounts of concessional contributions carried forward.

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