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It’s been difficult for investors in other countries to generate an investment income for several years now, however Australians have only recently needed to look beyond cash for attractive yields.

Cash holdings in households, and both institutionally managed and self-managed superannuation funds, have been steadily rising since 2007. Glenn Hart, co-head of equities at Antares, says that as interest rates fall, holding cash is unsustainable in the longer term.

The rates on three-year term deposits have recently ticked down. They’re close to the same level as the dividend yield of the S&P/ASX 200, which Hart says is unusual.

Most economists believe cash rates are heading lower – some say to 2 per cent by the end of the year.

Bob van Munster, head of Australian equities at Tyndall Asset Management, says the market is already pricing in further interest rate cuts in 2013. From here, the main driver of dividend growth, and therefore market improvement, will be a rise in company earnings, he says.

But there are traps investors must avoid when looking for yield from the sharemarket.

DON’T GET CAUGHT OUT

“When determining whether a stock is good value or just a trap, investors need to assess the underlying health of the company and the sector in which it operates,” van Munster says.

A high dividend yield could imply a company’s share price is cheap, but van Munster warns it could be cheap because the business is struggling.

“Deteriorating businesses can often have a high dividend yield that proves to be an illusion,” he says.

WHAT TO LOOK FOR

To identify companies with sustainable yield, earnings growth and capital appreciation potential, start with the following steps.

■ Look at the company’s gearing level. Average gearing levels in Australian companies are at 30-year lows, but there are exceptions.

Debt to equity ratio is a useful measure. It is calculated as the company’s total liabilities divided by the total amount of shareholder money invested in the business. A higher ratio potentially indicates higher risk and a more aggressive approach to financing.

■ Check franking levels. Franking credits are valuable to income-seeking investors as they are used to offset tax that needs to be paid on the income.

■ Consider the potential for buybacks, which reduce the number of shares on issue. This means there are fewer units to share the distributions, increasing the amount that each of the remaining units receives. Remember, though, that companies buy shares back from investors when they can’t identify better investment opportunities. It’s not necessarily a good sign for a company that plans to grow.

■ Consider the industry in which the company operates. For example, the manufacturing sector is challenged by the strong Australian dollar and high operating costs, while retail industries face growing competition from online shopping and changing consumer behaviour.

■ Think ahead. Some investment specialists analyse what would happen to particular companies in different scenarios.

Van Munster cites the banks as an example. Right now they’re paying good dividends but what about in future? If credit growth increases from about 7 per cent to 8 per cent, banks will need to divert capital from dividend payouts to fund the increase.

Alternatively, if the economy deteriorates, and bad debts rise as credit growth falls, bank dividends could also be in jeopardy. Van Munster believes both of those scenarios are unlikely, but it’s a usefule exercise to consider different scenarios.

For some ideas on which stocks to target, have a look at AFR Smart Investor’s recent lists of best yielders on the ASX and most reliable earners on the ASX.

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