The hunt for income

Crises, such as the Global Financial Crisis and the COVID-19 pandemic, inevitably throw up challenges for companies and investors alike. Generating and sustaining investment income is one such challenge. As corporate revenues fall, the potential for dividend cuts and credit defaults increases. 

Despite being an ever present potential risk to investors, dividend cuts were catapulted to the forefront of the investor psyche in Q1 2020, as an unprecedented number of companies announced they were cutting or suspending dividend payments. In this case, however, the extraordinary number of dividend cuts and suspensions were not all simply a corporate response to dramatically suppressed consumer demand following the lockdown measures imposed by governments around the globe. There were a myriad of other reasons too:

• Regulatory pressure to suspend pay-outs, as seen in the Banking and Insurance sectors
• Environmental, Social and Governance (ESG) purposes, as companies were keen to demonstrate their commitment to key stakeholders beyond equity investors; their employees and customers
• To free up cash for opportunities that may arise from a period of economic disruption and upheaval
• In response to taking Government support

By mid May 2020, over 250 UK listed companies had cut or deferred their dividends, meaning that a sum amounting to c.£38bn would not find its way to investors accounts¹. Even companies with decades’ long unbroken track records on dividend payments have not been immune; Royal Dutch Shell cut its pay-out for the first time since World War 2, as the oil price collapsed. 

So what does this mean for income investors?

Not all dividend cuts are the same

Firstly, whilst dividend cuts are most often viewed as a negative sign for a company’s financial health, it is important to recognise that this is not always the case. A cut from a position of strength is very different to a highly leveraged company reacting to suddenly reduced revenues trying to stave off a cash flow problem. 

Therefore, even income investors should occasionally welcome news of a dividend cut. Capital returns are part of the equation to grow income over time. If a company can reinvest its capital to make more attractive risk adjusted returns then it will grow profits and should be able to afford larger dividends pay-outs in the future. As is so often the case, it pays to be a patient investor.

This is also why, counter-intuitively, the highest yields are not necessarily the most attractive for income hunters. Higher yielding shares are often associated with a mature company, paying out most of its profits as dividends. This leaves little money to invest in the future growth, and over time the attractions of that yield may decline as it fails to grow, or even worse the industry falls into decline. Although they will usually have their place within an equity income mandate, looking further afield than the likes of high yielding UK blue-chip companies can provide investors with the opportunity to find dividend growth, be it in the mid-cap sector or overseas.

Is there a silver lining to companies cutting dividends and stopping share buybacks?

Yes; especially for multi-asset investors. Measures taken to reduce cash outflow, such as lowering dividends or the ending of share buybacks, make for stronger balance sheets. A company announcing a cut to its dividend will often disappoint equity holders, but for bond holders of the same company it can be welcome news; shoring up the company’s balance sheet to ensure it can continue to make good on its debt obligations. 

New equity issuance, something witnessed quite regularly in the wake of the COVID-19 fallout, has a similar effect. As an equity holder, new equity issuance will most likely disappoint you; diluting your shareholding. However, it presents great opportunities for fixed income investors. Raising equity by issuing new shares can also shore up the creditworthiness of a company. Should corporate bond yields rise sharply in times of crisis it can present fertile ground for income hungry investors.  In April 2020, for example, a number of insurance companies had to raise equity to offset the expected losses from COVID-19 claims, while this served to shore up the firms’ balance sheets, the bond yields of the same companies had previously moved to appreciably higher levels than they were pre-crisis. This is one way in which active multi-asset investors are still able to find or maintain portfolio yields, despite a challenging environment.

Don’t let the income tail wag the investment dog

Without careful scrutiny, too great a focus on yield can sometimes lead to irrational decision making and poor investment outcomes. For example, within fixed income markets, focusing on high yielding bonds might help fulfil an income target on paper, but it may not be optimal for your long-term goals. Yields compress as asset prices rise. If a high level of income is your primary concern, one may be tempted to seek investments higher up the risk spectrum within fixed income securities – such as non-investment grade, so called junk bonds. However, in reality, as markets get more expensive (compressing yields) you may want to be reducing your risk, not increasing it. Reducing risk might mean reducing high yield bond exposure, reducing the duration of the fixed income portion of the portfolio, or even increasing an allocation to cash.  Of course, this may have a negative short-term impact on the forecasted yield of a portfolio, but it should protect capital in a downturn and ultimately leave investors with a greater capital sum to put to work.

In 2019, the Close Diversified Income Portfolio Fund bought UK government bonds (Gilts) for the first time since 2011, along with highly rated corporate bonds due to mature in 2020. These bonds offered yields between just 0.7%-1.1%; clearly they were not bought with a big yield target in mind, but instead due to an investment process that dials down risk as valuations begin to look excessive.  The capital preserved can then be re-deployed in much higher yielding opportunities when the market is cheaper. March and April 2020 presented investors with exactly that opportunity; a chance to switch those low yielding assets, such as Gilts and cash into new ideas at much more attractive yields. This is a well-trodden path for the Fund, as a very similar scenario played out back in 2011, bolstering yield and ultimately risk-adjusted returns.

Diversification is key

Diversification is the bedrock of modern portfolio theory. An appropriately diversified asset allocation and diverse source of income streams (from different industries, asset classes, geographies, and public or private sector driven projects) will help to smooth the inevitable bumps in the road that come investors’ way from time to time. As we’ve seen, these can include unexpected regulatory changes, a sudden crisis, changes in interest rate or inflation expectations, a change of government, or a cyclical period of economic contraction. One must always remember that all investments carry risk and at various points those risks can become more stark and painful for certain asset classes or investment ‘styles’ than others. For example, in recent years there have been calls in some quarters to end Private Finance Initiatives (PFI) – under which private companies provide public services and infrastructure – and to bring existing contracts under state control. Suddenly, an inflation-linked government backed income stream became a much more risky investment than previously thought, and their share prices reacted negatively as a result. It would have been easy for some investors to quickly cut their losses and reinvest the proceeds into an area that was not under such scrutiny, but such a knee-jerk reaction is rarely wise. Investors will sometimes have to be patient for returns to materialise from certain parts of their portfolios, or for transitory risks to pass. In the meantime they should be able to lean on other areas of the portfolio for support as long as they are sufficiently well diversified. 

The COVID-19 outbreak was a major shock to the system on many fronts and a global pandemic was certainly not something many investors would have had too high on their list of potential risks going into 2020. Future systematic shocks could stem from many sources; there are the known unknowns, such as the damage a virus of the cyber kind might cause, for example, or the unknown unknowns. In truth, investors can never fully know what might be coming around the corner, so just as one should diversify by asset allocation, so too should investors continue to look for ways to diversify their income streams. As an already challenging environment for income focussed investing becomes even more challenging, we continue to seek out the best-risk adjusted opportunities, while ensuring diversification across asset classes, market capitalisation and income streams helps to achieve your clients’ investment objectives.

¹Source: Numis

Important information
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients. The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This article is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.