Income investing during COVID-19 – Q&A with Chris Ainscough

Charles Stanley Monthly High Income Fund manager, Chris Ainscough, provides his views on the outlook for dividends and how income investors could react.

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How bad is the dividend situation – is this really a crisis?

The high levels of volatility and a recent raft of dividend cuts and cancellations, both in the UK and overseas, have left equity investors checking their dividends are safe. Many companies will suffer a partial or complete collapse in revenues, unlike previous recessions when revenues have been dented but not fallen to zero. Markets currently imply a decline of around 50% in 2020 dividends in Europe versus 2019 and a 20% decline in the US which is a lower yielding market anyway.

Drill down and the underlying picture is complex. Some companies in sectors such as consumer goods and healthcare are relatively unscathed, whereas those in more sensitive areas such as travel, leisure and energy have been most acutely affected. That’s exacerbated for businesses with stretched balance sheets with lots of debt. We are also seeing companies that will most likely have minimal business interruption adjust dividends just to be on the safe side.

Overall, we see the dividend picture as highly uncertain still, but it will likely build back from a lower ‘base’. For many companies, the dividend hiatus is short term. Both capital losses and disruption to income are likely to be painful for investors, but once restrictions on consumers are lifted, and we move past the crisis, companies will most likely return to distributing cash as soon as they can. The UK has always stood out as an anomaly on the global stage with a substantially higher dividend yield than most developed markets, which has left it more exposed to cuts.

What about bonds? Is the income from them safe?

Bond investors hold the debt of companies, governments or other institutions so just need that company or entity to survive, rather than thrive, to get paid their interest. Although there will be a wave of bankruptcies and some bonds, especially in riskier high yield areas, will default, the overall shorter-term income picture is much healthier than with shares.

With just over 65% of the Charles Stanley Monthly High Income Fund invested in bonds, we are fortunately insulated from the worst of the falls in cash distributions being seen. There are provisions within the terms of some bonds that allow for interest payments to be deferred, but we are yet to see one of these used within our portfolio holdings.

There could also be some significant opportunities within bond markets as we often see overreactions to crises. Companies looking to issue new debt are currently paying a premium to do so, which can give debt holders with fresh cash to invest the ability to lock into an attractive income.     

How could investors relying on the income from their investments respond to the wave of dividend cuts and suspensions from UK-listed companies?

There is no easy answer. No one really knows how long the impact of the virus is going to last. Many firms are expected to reinstate dividends in the near to medium term, but some income staples like BT (not held in our portfolio) have guided that the dividend cancellations won’t just affect this year but also next, which might indicate a longer period before recovery for the part of the market where things have structurally changed. The picture is mixed and to some extent unpredictable, which means diversification is really important.

If you have a diverse portfolio, incorporating other areas including bonds, your level of income will be more resilient. There will be a dip, but it will likely be shallower and shorter than having a portfolio concentrated in previously high yielding economically sensitive equities, particularly among the FTSE 100.

As a general rule, if you’re relying on investments to provide an income, you should try to leave your portfolio alone and only draw on your capital when absolutely necessary. Selling and reducing capital to top up desired income can mean exiting at depressed prices and missing any recovery in share prices as the crisis passes.

What’s been your reaction? Where can you find companies that will maintain their dividends through the downturn and emerge stronger on the other side?

We look to invest for the long term, so we don’t generally react to shorter term movements unless we see either a real opportunity or a material risk. Within our equity allocation in Charles Stanley Monthly High Income, 9 out of 29 positions have so far adjusted, postponed or cancelled dividend payments. Given what we are going through, we would rather companies conserve cash and ensure they remain viable businesses than stretch themselves by distributing income; so, it is not a rule that we sell when the dividend is cut.

The only equity we have sold since the crisis began in earnest is Marston’s, the pub and brewing company. With the entire pub estate likely to be closed for months and an already stretched balance sheet, we took the decision to exit. Unfortunately, social distancing and pubs really don’t mix so we would expect creditor negotiations to be required and potentially new equity raised.

The proceeds of this were put towards a new position in The Renewables Infrastructure Group, which has a diverse portfolio of renewable energy generating assets. We accept that there may be pressure on their asset prices in the short to medium term with falling power prices but believe in the long-term structural growth of this market segment. We like infrastructure trusts for their income and inflation-linkage to revenues, so we also have positions in HICL Infrastructure, International Public Partnerships, Greencoat UK Wind and Foresight Solar.

We have been more active within the fixed income allocation as new issues have come to the market and prices fell to attractive levels. Issuers that we have purchased bonds in include Vodafone, British American Tobacco, Royal Bank of Scotland and AB InBev. We decided to exit one small debt position in John Lewis who are unfortunately exposed to the heavily impacted retail sector. With the equity in a partnership structure, they also have limited access to capital beyond the banks and credit investors, which may become an issue.  

Is it a good idea to take a more global approach and look for dividend payers around the world?

Having a bigger investment universe is almost always a better option. When it comes to income, however, as touched upon earlier, the UK really does stand apart from the rest of the world in terms of the higher yields available. If you can afford to drop your income requirement from over 4% to a more modest 2% or 3% then there are certainly lots of interesting and high-quality stocks to consider internationally.

When investing overseas you also must take into consideration any additional costs of doing so. These may include currency transaction costs to buy and sell the investment as well as extra custody charges to hold the position. If you are not able to hedge the non-sterling exposure, then there may be an additional risk through movements in the currency too.

There are some vehicles which cater for the desire for income while gaining exposure to overseas stocks. An example of this that we hold in the fund is the BlackRock North American Income Trust. This invests in equities across North America but since it is an investment trust, it can pay out capital as income if desired, though this will reduce the capital upside available. The current dividend yield is over 5%, which compares favourably to the broad US market which generally yields around 2%.

Is there a correct style of income investing? Is the value approach of buying cheap, high-yielding shares now defunct?

I think flexibility is the most important thing to maintain when investing for income. Being able to hold a large range of asset classes, equities, government bonds, corporate bonds, preference shares, funds and so on, allows for diversified sources of income and hopefully resilience through tougher times.

Value as a style has been a very poor performer for a number of years and there are certainly “value traps” out there. I am personally quite critical of trying to invest for income passively since formulaically buying the highest yielding stocks can expose you to value traps, poor performers and those likely to cut their dividends in the future.

If you are looking at creating a portfolio of stocks to generate a yield it is worth remembering that not every one of them has to hit your income target. Blending some slightly lower yielding equities with the higher yielding ones can still generate the average income you want while hopefully providing a realistic chance for capital growth too. We hold AstraZeneca, for instance, in the portfolio which now yields less than 3% but has posted a capital return of over 50% in the last year.

What has been the impact to the income from the Charles Stanley Monthly High Income Fund?

We've taken the decision to reduce the income payment from the fund in the interim to reflect the current circumstances and the uncertain market outlook. Having paid out an average of 0.36p per month through last reporting year (ended 31st Jan 2020) we took the decision to reduce this amount once the extent of the pandemic became clear. For the last two months, we have distributed 0.30p in each, while retaining some income within the fund. This is designed to ensure that we meet the accounting requirements if any income payments we are due are defaulted on, as well as smoothing the income distributions over the year.  

With 9 of our 29 equities cutting dividend payments so far, we will certainly pay a lower total distribution for the year, but we have a good deal of protection from the majority of our assets being bonds.

Going forward how will the picture for UK dividends and funds investing in dividend-paying shares change?

For equity income funds, a requirement to yield 110% the FTSE All Share Index dividend yield for Investment Association sector inclusion (temporarily waived presently) has hugely constrained stock selection and corralled managers into holding the large, high dividend paying index constituents. There has been a concentration of dividends historically in the UK amongst the five biggest payers – historically banks and energy companies have made up 38% of the UK market yield – and this forced sector skew has led to poor performance.

Dropping the yield bar to, say, a 3% income yield expectation will allow for greater consideration of capital prospects. With many of the large payers cutting, the market’s income profile broadens out and, going forwards, investors will be less reliant on a handful of firms. So, although the income obtainable across the market will be lower, it should be more diverse and therefore lower risk. Furthermore, interest rates on cash and government bonds are exceptionally low, so a sizeable relative income spread over ‘safe’ assets still exists. This could ultimately push people towards the equity market for income.

Finally, it’s vital not to give up on dividends. Their importance to total returns tends to increase in low-growth times. For the long-term investor, dividends should continue to make a gradual but powerful contribution to long-term total returns, helping mitigate the effects of both market falls and inflation.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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