This year had been forecast to be a bumper year for income investors, with more than £100bn of cash expected to be returned to UK shareholders. However, the economic shock from coronavirus has proved deadly for dividends.
Annual payments could be less than half of this level, according to financial services provider Link Group, as companies cut, suspend or review dividend payments to shareholders as they hang on to cash to weather an uncertain future.
More than 40 per cent of British companies have already cut dividends this year and more are expected to follow. Link forecasts payments totalling £52bn are at risk.
Having seen capital values plummet since the global sell-off began in late February, private investors have been dismayed by dividend cuts which have not only hit their income, but caused share prices of affected companies to fall further.
This has had a disproportionate impact on older investors who rely on investment income to fund their retirement, including hundreds of thousands in “pension drawdown” plans who remain actively invested in retirement and generate an income from their investment pot.
FT Money assesses the options for income-seeking investors, considering the growing concentration of dividend risk, the strategies professional fund managers are taking to bridge the income gap, and practical tips from investment experts.
As the options for income seekers narrow, investors must be wary of concentration risk as the pool of FTSE dividend-paying companies shrinks.
Companies in hardest-hit sectors such as the retail, travel and leisure industries have been forced to axe dividends as they battle to survive.
Others, such as UK banks, have been pressed to cut dividends by the government. Many insurers including RSA, Direct Line, Aviva and Hiscox have also bowed to regulatory pressure and suspended payments.
Others are reluctant to pay out in the event that they will require government assistance further down the line and some have used the pandemic as an opportunity to lower dividends discreetly from a previously high level, sparking the ire of investors.
“Political intervention is the biggest unknown for the income sector,” says Mike Kerley, fund manager of Henderson Far East Income. “The blanket restrictions the government put in don’t necessary reflect the credibility and financial stability of the banking sector.”
“Housebuilders went into this with a net cash position, so that did catch us by surprise,” says Laura Foll, co-manager of the Lowland Investment Company, and income focused investment trust.
Yet she adds that investors who chase other dividend-paying companies could find themselves in a value trap or overexposed to sectors in permanent decline, such as tobacco, which has both “structural and volume decline, but high dividends”.
Just 10 firms are forecast to pay out two-thirds of FTSE 100 dividends this year, notes Russ Mould, investment director at AJ Bell.
Currently, the top 10 payers are expected to include Shell, BP, British American Tobacco, GlaxoSmithKline, Rio Tinto, AstraZeneca, Vodafone, BHP Group, Imperial Brands and Diageo, according to Sharecast analysis of Refinitiv data.
Shell and BP have been favourites of UK income investors for years, but the dramatic collapse in oil prices this week has caused huge concern about future dividend payouts.
“It would be ground zero for UK dividends if Shell or BP pulled their dividend because they’re two of the top five payers in the UK market, and over a third of the dividend market is from the top five,” notes Jason Hollands, managing director at Tilney Group.
With oil prices at such distressed levels, there is nervousness at how sustainable the payouts are. On Thursday, Norway’s Equinor became the first oil major to cut its dividend, blaming the “extraordinary” market situation.
“Shell hasn’t cut its dividend since World War Two, but if they were ever going to do it, this is the time,” says Alasdair McKinnon, manager of the Scottish Investment Trust.
Mr Mould says BP and Shell are “fiercely proud” of their dividend record, noting how both companies have emphasised in recent trading statements that cuts to capital investment, cost reductions, asset disposals and fresh debt would provide ample liquidity, suggesting they were “determined to defend their planned payments”.
“If either BP or Shell were going to cut their dividend, it would only be for one quarter,” he says.
Some investors will be hoping that companies that weather the storm will reward shareholders with special dividends at the end of the year, but analysts caution that this is increasingly unlikely.
“Sourcing liquidity to survive the Covid‑19 crisis requires sacrificing equity investors,” says Nicholas Ware, portfolio manager on the strategic fixed income team at Janus Henderson Investors. “The recent dividend cuts are likely to become the norm.”
If anything, companies could use widespread dividend cuts to lower the level of annual payouts in the future.
“We should expect some of them to reset their dividend policies permanently as result,” says Margot von Aesch, head of income research at Redburn, the investment research group. “Dividends could take a rather long time to recover fully to previous highs.”
Funds starved of income
Dividend cuts have also knocked the performance of income funds, forcing fund managers to turn away from traditional income stocks and consider new strategies to weather the coronavirus pandemic.
Just 25 per cent of equity income funds have outperformed the FTSE All-Share index since the start of the year, according to returns data from Interactive Investor.
On Wednesday, the Investment Association prevented more than 140 UK and global funds from being ejected from its “equity income” classification by relaxing the rules on the minimum payments they must make to investors. The industry body’s guidelines will remain in place for the next 12 months.
Adrian Lowcock, head of personal investing at Willis Owen, says the move will help protect investors. “Fund managers will not have to chase income by clustering into a minute number of companies who are still able to pay dividends.”
However, plenty of income fund managers had built large holdings in small- and mid-cap UK income stocks before the crisis hit — a strategy that has fuelled underperformance.
Compared to large-cap equity funds, income funds were almost twice as exposed to FTSE 250 companies and more than four times as exposed to UK small-cap companies, according to data from Morningstar.
Total returns for FTSE small-cap companies in mid-April were down 27 per cent since February 19 and down 29 per cent for the FTSE 250. By comparison, UK large-cap equity funds were down 24 per cent over the same period.
Investors in income funds could see payments cut by 30 per cent this year, says Tom Rosser, investment research analyst at the Share Centre. “For those with more exposure to travel, retail and banks, this figure could be greater,” he warns.
Two funds that had been hugely popular with income-seeking investors managed by Invesco’s Mark Barnett — the poster boy for income funds — have shrunk at an alarming rate as dividend payments dry up.
Throughout April, Mr Barnett’s £3.4bn High Income fund and £1.5bn Income fund — both made popular under the stewardship of Neil Woodford — shrivelled by £650m and £267m respectively, according to data from FE Fundinfo, a fund data provider.
Mr Barnett was also fired as manager of the Perpetual Income and Growth Investment Trust after poor performance.
Invesco’s troubles are echoed across the market as income funds suffer significant outflows. In the month to April 21, Schroder Income topped the list with £62.8m in net outflows, followed by LF Milton UK Multi Cap Income and Artemis Income, according to data from FE Fund Analytics.
Amid the dividend drought, managers of income funds are deploying a range of strategies to shore up performance. Some fund managers have responded by shifting their investment strategy towards capital growth.
“The best capital growth opportunities are with companies that have suspended their dividend,” says Ms Foll.
Henderson’s Mr Kerley says that when his fund removed exposure to banks from its portfolio, he turned to companies “that might not be household names for income, but might give you that capital growth when you get a recovery”.
He has increased his fund’s exposure to China from 20 to 30 per cent this year, focusing on the infrastructure, construction and building materials sectors as these are likely to benefit from government efforts to revitalise a wounded economy and ease unemployment by building high-speed rail and roads.
The sectors that managers are more positive about include consumer staples, which have seen demand hold up under lockdown. Johnson & Johnson announced a 6 per cent increase to its quarterly dividend last week even though annual guidance has been cut due to the coronavirus. “People are not going to buy a car, but they’re going to buy toilet roll,” adds Mr Kerley.
Others have targeted industries such as shipping, as energy producers stockpile excess oil in on-sea tankers waiting for demand to return. Mining, commodities and healthcare stocks have also attracted attention.
The lockdown in China prompted Alasdair McKinnon, manager of the Scottish Investment Trust, to divest from UK retail, banking and oil stocks, turning to gold, utilities and telecoms. “It meant we were selling high-yielding stocks, but in many cases they’ve since confirmed they’re not going to pay dividends,” he says.
Income fund managers are increasingly shifting their geographical focus, as Asian countries start to loosen controls and revitalise businesses. “China has the best chance of seeing some kind of recovery in the second half of year,” Mr Kerley says.
“Dividend Heroes” is the name given to investment trusts that are hard-wired to survive dividend droughts. The Association of Investment Companies publishes an annual list of trusts that have increased their dividends every year for more than 20 years. There are currently 21 on the list; City of London is at the top with an unbroken 53-year record.
The closed-end trusts, which trade at the value of their underlying assets, can hold cash in reserves to smooth out income payments in turbulent years. Many hold as much as three years worth of annual dividend payments.
However, returns from investment trusts can be small relative to open-ended funds, and discounts to the net asset value reached their widest point since the financial crisis in the market sell off. Trusts can also hold more illiquid assets, such as property, which has suffered as valuations become uncertain.
For investors looking for certainty over returns, advisers say that trusts could be a prudent buy. Laura Foll of the Lowland Investment Company notes that investor interest in the sector has increased markedly in recent weeks as investors hunt for income.
On Thursday, the Alliance Trust declared an interim dividend 3 per cent higher than a year previously. When paid in June, it will have increased its dividend for 53 years in a row.
According to a survey by Interactive Investor, of the 23 per cent of investors who were looking to make changes to their portfolio’s risk allocations, 12 per cent said they are looking at investment trusts.
Asian companies have been more reluctant to slash dividends, adds Tom Delic, a fund manager at Seneca. He notes that Japanese companies in particular tend to maintain high levels of cash on their balance sheets.
“It still feels like you’ve got capital upside from cheap valuations, but you’ve still got the trend of Japanese business being more shareholder friendly and increasing dividends,” he added.
Other income fund managers are eyeing the corporate bond market. “Corporate bonds may be more illiquid than equities but they are fundamentally less risky,” says Mr Ware at Janus Henderson.
“Investment-grade corporate bonds offer significantly more yield than before and more than compensate for increased risk to downgrades that would normally happen in period of recession,” says Mike Coop, head of multi-asset portfolio management at Morningstar Investment Management.
But advisers caution that fixed income is a complicated terrain to navigate for DIY investors — particularly given the heightened risk of corporate failure.
Steve Drake, a wealth manager for Royal Bank of Canada, says retail investors looking to buy fixed income needed to ask difficult questions, assessing the likely credit risk, and how interest rates could change over the lifecycle of the bond.
In such an uncertain climate, he prefers shorter maturities of less than three years. “The longer the maturity, the more interest rate risk you have,” he says, adding that investors should never forget that markets are efficient: “If [the yield] seems too good to be true, it probably is.”
Investors adjust to the new reality
As investors adjust to the realities of dividend cuts, those who are managing investments in retirement are feeling an immediate impact.
“Investors have endured an incredibly punishing month,” says Jon Green, head of retirement policy at Quilter. “This is especially troubling for people either in drawdown or approaching retirement due to the potentially damaging impact on retirement income plans.”
In the five years since pension freedoms, hundreds of thousands of investors have gone down the drawdown route, aiming to live off the income generated by leaving their pension invested rather than buy an annuity.
A recent survey from Interactive Investor survey found that one in five investors didn’t know what to do in light of the dividend cuts. Those with immediate income needs could of course sell down some of their holdings, but this would crystallise losses.
Mr Green stressed it was important for investors in drawdown to stay invested. However, investors managing the income crunch may need to consider reducing their level of withdrawals, taking income from other savings or investments or even delaying their retirement.
Steve Drake, a wealth manager with Royal Bank of Canada, adds that when investors estimate their annual living expenses in retirement, these should never equal the amount they expect to receive in income from their investments.
“You wouldn't wire electricity for average usage,” he says, adding that he advises his clients to target a smaller percentage to allow for drops in income that come with market downturns.
FT Money readers are adopting a more flexible approach.
“A 50 per cent dividend cut all around would be uncomfortable, but I don’t think it would be permanent,” says 80 year-old retired painter and investor Denis Pannett who draws income from his investments, a state pension, a small work pension and his art business.
He has been burnt in the past by chasing dividends. “I’d invested rather badly in Anglo American right before the sell-off because they gave a good dividend, but they were hit hard.”
He uses dividends to fund his extras, covering one-off expenses like a new boiler, and building up his family’s level of savings for a rainy day. As an investor, he has learnt that “any dividend could be cut at any time”.
Mr Drake is more brutal in his assessment of the options for investors living off their dividend income. “If dividends get cut, you just have to spend less money,” he says, adding that investors should always have cash reserves to draw on in times of market volatility that can be rebalanced in the future as markets recover.
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