Why it pays to diversify in the search for income
Careful stock selection and diversification into other income-producing assets are key to generating income this year, say Trevor Green and Nick Samouilhan.
The search for El Dorado, the lost city of gold in South America, lasted for hundreds of years, cost countless lives and is reputed to have driven many men mad. The hunt for income hasn’t lasted quite as long, but as we approach the seventh anniversary of the Bank of England’s move in March 2009 to reduce interest rates to a record low of 0.5 per cent, it shows little sign of ending. With fixed income yields offering little in the way of return – at least from those sovereign issuers considered low risk – it is unsurprising investors have turned to equities in the belief that they could provide a reliable flow of income in the form of dividends.
Dividends under pressure
However, equity income investors endured a choppy ride in 2015 and conditions will remain challenging in 2016. Average dividend cover – the ratio indicating how many times a company can make its scheduled dividend payments out of its net income over a set period – declined to 1.52 across the FTSE 350 Index at the beginning of 2016, from 2.4 at the end of 2011, according to the Financial Times.
Chart 1 Decline in dividend cover, rolling 12-month periods, 2008-2015
Sources: The Share Centre and Capita Asset Services, 28 September 2015
The higher the ratio, the more affordable it is for a company to pay and sustain its dividend. Payouts are considered under threat if the cover falls under 1.5. The ratio has been falling for over four years and is well below the level reached during the global financial crisis (GFC). It fell below 1.8 following the GFC, having last dropped under that mark in 1999.
As we approach the seventh anniversary of the Bank of England’s move in March 2009 to reduce interest rates to a record low of 0.5 per cent, the search for income remains as intense as ever – the answer we believe lies in a diversified approach to income-producing assets.
Depressed commodity prices weigh on dividends
The sharp fall in commodity prices is a key factor in the recent decline. The miners Anglo American and Glencore suspended dividend payments in 2015, and there is a risk that others could follow suit as falling metals and commodity prices take their toll. Declining oil prices are also hurting some dividend-paying heavyweights in the energy sector. In February 2016, for example, Royal Dutch Shell reported profits of US$1.8 billion for the fourth quarter of 2015, less than half the US$4.2 billion reported in the same period a year earlier.
Royal Dutch Shell has not cut its dividend since 1945, and will do everything it can to avoid doing so. However, its current forecasts are based on a crude oil price of $60 a barrel in 2017. Given the current trajectory of oil prices, it may be forced to re-examine its dividend policy. BP is in a slightly better financial position, having had to reduce the scale of its operations and sell assets to fund the reparations following the Macondo oil rig disaster in 2010. However, given the oil price, BP will not cover its dividend from internally-generated cashflows until 2017 at the earliest.
Wage costs pressure grocers
Meanwhile, food retailers such as Tesco, Sainsbury’s and Morrisons have already all cut their dividend by over 50 per cent. The introduction of the new National Living Wage in April 2016 will pile further pressure on the supermarket operators, with wages accounting for a relatively high percentage of their cost base. The same is true of low-margin, labour-intensive support services such as manned security providers and low-margin clothing retailers.
Scanning a wider horizon
In this environment, investors must look elsewhere for income. Despite the difficulties afflicting traditional providers of dividends such as mining stocks, there are a number of companies with conservative payout ratios where there are better prospects for dividend increases.
Moreover and despite the adverse headlines, the current state of balance sheets in the UK corporate sector is healthy overall and not all of the cash companies generate will be spent on M&A, particularly given the fragile global macro backdrop. Companies such as ITV, the London Stock Exchange, UDG Healthcare, easyJet and MoneySuperMarket.com could increase their payout ratios or pay special dividends.
Excluding the mining sector, revenues among the UK’s largest 350 listed companies rose 12.9 per cent in the third quarter of 2015, up £8.3 billion year-on-year, according to the Share Centre1. Pre-tax profit soared by 19.8 per cent to £8.8bn, excluding mining companies, which experienced a 64.7 per cent decline.
It is also worth looking outside the UK where, despite the challenging earnings picture, dividends are not under as much pressure. Around the globe, there are still many good companies that can grow their dividends by more than 10 per cent, particularly in sectors such as consumer discretionary, healthcare, technology and telecoms where companies are generating sustainable levels of free cashflow.
Europe certainly has many high-quality companies paying sustainable income streams and, unlike in the UK, they are widely distributed across sectors, and well covered by earnings.
Outside of dividends, there are a number of other potential sources of income, including commercial property, government and corporate bonds. Each has their pros and cons.
Commercial property, for example, can provide a steady income stream and, given returns from the sector have a relatively low correlation to bonds and equities, it also offers diversification benefits over the long term. Real estate investment trusts (REITs) provide tax‑efficient access to the income opportunities available from property.
However, REITs’ share prices move in tandem with broader equity markets during periods of short-term stress, as was highlighted during the August 2015 sell-off, sparked by concerns over China’s slowing economy. After several years of strong gains, the current real estate cycle is approaching maturity. And REITs are vulnerable to interest rate hikes just like other assets. But the fact interest rates are likely to rise only slowly suggests that the downside risk facing REITs is limited and that the income they provide will remain relatively attractive. The FTSE EPRA/NAREIT UK Index achieved a dividend yield of 2.95 per cent and distribution growth of 10.09 per cent in 2015, according to Bloomberg.
A safe haven
Government bond yields have fallen sharply in recent years. On 11 February 2016, for example, the yield on 10-year UK gilts dropped to an intra-day low of 1.23 per cent, according to Bloomberg.
Which begs the question: why have exposure to government bonds? The answer, we believe, is that firstly, interest rates are likely to rise slowly and peak at much lower levels than in the past. So we do not expect government bonds to sell off dramatically. Secondly, core government bonds still have an important role to play in protecting portfolios from market turbulence.
When global markets sold off at the beginning of 2016, for example, the price of core government bonds such as US treasuries, German bunds and UK gilts rallied and helped to offset the impact of the drop in equities. It is also possible to build a balanced government bond portfolio with a diverse range of sources of both income and returns that include core and emerging market government bonds.
Opportunities may also be opening up among emerging market local currency government bonds. Since 2011, emerging economies have experienced major currency depreciation and deteriorating terms of trade as commodity prices have fallen and global trade has slowed. Despite speculation to the contrary, emerging economies have, broadly-speaking, maintained their stability throughout this period.
Moreover, a long and painful period of economic adjustment is having a positive impact on structural imbalances. Emerging-market currencies have reached attractive levels on a long-term basis and now local-currency bonds offer decent value relative to other asset classes.
Chart 2: Yields on local currency emerging market bonds, 2011-2016
Source: Bloomberg, February 2016
Balancing the risks and rewards of corporate bonds
Yields on investment-grade corporate bonds have fallen sharply in recent years. To some extent, this reflects the broader picture in government bond markets, but also the fact that certain major multinational corporate issuers, such as Apple and Microsoft, are viewed as carrying lower risk than sovereigns. However, on a selective basis it is still possible to find value in investment-grade credit; which also applies to some high-yield and emerging-market issuers.
Despite macro headwinds, default rates remain low, reflecting the broad-based drive to repair balance sheets in the wake of the financial crisis. In December 2015, ratings agency Moody’s predicted the default rate for global speculative-grade bonds would end 2015 at 3.0 per cent before rising gradually to 3.7 per cent by November 2016. It added that if its 2016 forecast proved correct, the rate would remain below its historical average of 4.2 per cent and that the rise in defaults would be concentrated among commodity companies.
One potential risk to this forecast, however, is of a major liquidity event. With post-crisis regulatory reforms already impeding the ability of banks to provide liquidity in their role
as market makers, there are legitimate concerns over what could happen in the event of a major market shock.
In summary, the picture is mixed across traditional sources of income. While there are headline risks in each asset class, scratch beneath the surface and there are still opportunities. Such an environment tends to favour a diversified approach rather than a heavy bias towards one or two asset classes.
- Stock selection will be key for UK equity income investors in 2016
- Some companies could increase their payout ratios or pay special dividends, while others cut or suspend payments
- Income investors could also choose to diversify beyond dividends
- While there are headline risks in other income-producing assets, there are also opportunities