Following the October rate cut, cash rate futures are now pricing in a rate of 2.50% by March 2013. At these levels, lower cash rates and bond yields remain supportive for quality dividend strategies, even before the franking.

Regarding timing for the next move, the market has effectively pencilled in a November Cup Day rate cut. The theme is simple enough, rates globally and domestically, are staying lower for longer. Cash returns will clearly be lower in 2012 compared with 2011 as term deposit rates continue to migrate lower.

A quality dividend strategy

Investors need to look to diversify portfolios across income-generating assets as term deposit rates continue to fall. Within the equity asset class, a focus on a quality dividend strategy across the defensive sectors aims to deliver an attractive income stream. This is generally a core strategy for retail investors.

Dividends provide an income stream that is often underestimated. In the last decade, dividends have accounted for an average of one-third of total equity returns. Dividend payments are a good surplus when stock prices are rising by providing capital protection while at the same time allowing investors to benefit from rising share prices. In sideways trending or declining equity markets, however, the dividend payment can act as a support. This explains why investments in stocks that offer high yields can be seen as defensive and less risky.

It is important not to forget the benefits through time of franking credits. For investors who are able to take advantage of franking credits, this could add an additional 1-1.5% to portfolio returns (note, at UBS Wealth Management we target closer to 2.0% franking for our retail dividend strategy portfolios).

Constructing a dividend strategy portfolio

Table 1 goes through some basic filters when constructing a dividend strategy portfolio. This should be used to build a core strategy. Depending on an investor’s risk appetite, they could add more risk. When determining companies to add to the Core Equity Income Portfolio, some of the metrics UBS Wealth Management consider include:

• A dividend yield above that average yield of the ASX 200, and above the 10-year bond yield;
• A lower-than-market beta value. The portfolio has a beta of 0.8. This implies the sensitivity of earnings are less leveraged to future economic cycles vs the broader ASX200 market;
• A dividend coverage ratio above 1.00;
• Generally, the company should have a market capitalisation of over $500 million.

Table 1

Important: No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities referred to in the materials. Any opinions expressed in this material are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of UBS. To the extent that UBS has sourced any material in this document from a third party, UBS accepts no liability for the accuracy, currency or completeness of that material. Prices, values, rates and yields are indicative only. UBS is under no obligation to update or keep current the information contained herein.