Following the collapse in dividends, is growth the new income?

As companies the world over reset their dividend policies, private investors need to also reset their overall return expectations and how they are accessed, says Andrew Pitts.

People seeking a meaningful income from their savings and investments have now suffered the third crunching blow in an injurious triple whammy. The initial “one-two” came from the steady reduction in rates of interest available from cash and investment grade bonds over the past decade. Then came this year’s “upper cut”, a wholesale collapse in equity dividends, particularly from UK-listed companies. It has hit private investors particularly hard, especially those who rely on income-producing funds to fund their retirement.

There is no respite in sight for interest on savings and bonds. In the meantime, the general expectation is for equity dividends across the developed world not to pass 2019’s record total for many years to come.

Although falling rates of interest from cash and bonds have been with us for a decade, the collapse in dividends means investors at large need to rethink how they invest and what they invest in to meet their personal goals, in particular those who have retired or are about to move from the accumulation to the “decumulation” phase of their financial journey. 

The three stages of income grief

First, interest on savings in general has fallen to a sub-1% level. It is difficult to call NS&I’s 1.16% interest rate on its income bond (with interest paid monthly) the saver’s saviour. Putting that into figures, a basic-rate taxpayer would need to deposit £85,750 to earn the £1,000 in annual interest allowable before a potential 20% tax liability kicks in (under the Personal Savings Allowance). Higher-rate taxpayers can deposit half that amount before interest becomes taxable at 40% or more. The Personal Savings Allowance enables basic-rate taxpayers to receive £1,000 of cash interest tax-free each year (£500 for higher-rate taxpayers and £0 for additional rate taxpayers).

Yields on government and other investment grade bonds have also now fallen well below 1% in aggregate. The Bloomberg Barclays Global Aggregate index, which includes global investment grade debt of various durations issued in 24 different currencies, now yields around 0.8%, according to Bloomberg data.

A little more than a decade ago, UK savers could still access accounts paying around 5% and the yield on this bond index benchmark, too, was around 4.5% before the global financial crisis (GFC).

As the decade progressed, however, interest on savings and bonds gradually collapsed, and savers increasingly have found themselves having to become investors to secure a half-decent income. The gentle melt-up in global stock markets over the decade helped to erase memories from the GFC, when the FTSE 100 index fell nearly 50% peak to trough. 

As yields from “risk-free” cash and bonds progressively collapsed, companies the world over bowed to investors’ clamour for income and borrowed heavily to fund their ever-growing dividends. The fact that much of this largesse was being paid for by debt rather than organic profits growth seemed to matter little in an era when stock markets just kept going up.

The bear market in dividends was relatively short-lived in the aftermath of the GFC, with payments generally back to normal by mid-2010. That is not going to happen this time. On a 12-month view, the yield for the MSCI World index is a little more than 2% (half the level of early 2009). For income-focused investors, the outlook remains bleak. 

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Over-distribution of dividends, particularly from “old-economy” companies such as miners and oil companies, has damaged balance sheets and has also been at the expense of business investment. Many traditional income-payers need to “reset” the level of dividends they pay, in proportion to their profits, and prioritise the conservation of cash instead. 

Research conducted by Schroders in May provides further grounds for pessimism. In a paper entitled “Dividend bear markets: the grizzly facts”, the asset manager found that although dividend bear markets have been very rare in 150 years of US stock-market history, they last far longer than bear markets for total return (growth plus income). 

Duncan Lamont, head of research and analytics, said:

“Although dividend bear markets have been less frequent, the painful news for investors seeking attractive dividends is that they have historically lasted much longer than those for total return: 4.8 years compared with 1.5 years, on average.”

Futures markets have priced in US dividend growth of 10% in 2022, but this would still leave them almost 20% below their level in 2019. “It is not until the end of 2027 that futures markets are pricing US dividends to get back to reach those heights again,” Lamont said. “It is a similar, or worse, story in other markets.” 

The UK is among those worst-affected markets. In its most recent UK Dividend Outlook, investor services business Link Group forecast that underlying payouts (which ignores one-off special dividends) could fall by up to 43% in 2020, to just over £56 billion. Laura Foll, who manages equity income funds at Janus Henderson Investors, thinks dividends will recover a little in 2021, but does not see a return to 2019 levels for several years.  

Proceed with a different outlook

Given the growing absence of underlying yield from traditional asset classes, income-seeking investors – particularly retirees drawing down from a self-invested personal pension (SIPP) – need to think less about generating actual income and more about the total return from growth and income.

To illustrate the dearth of income, the popular Vanguard LifeStrategy 60%, which has the classic mixed portfolio comprised of 60% global equities and 40% global bonds, currently has a historic yield of just 1.5%. But that yield is likely to fall further as a full year of dividend cuts is reflected in the future yield. 

Four years ago, a similar portfolio would have provided a 2% yield, according to Vanguard. In a paper published in January 2016 entitled “Total return investing: an enduring solution for low yields”, the authors pointed out that the natural inclination of most investors in retirement is to invest solely in income-producing assets. In the effort to close the gap between a portfolio’s natural yield – in this case 2% – and a widely followed annual spending goal of 4% of a portfolio’s value, the authors highlighted two potential routes.

“This spending gap can be resolved either by overweighting income-producing assets or by spending from the other piece of the total return, capital appreciation. Choosing to close the gap by over-weighting higher-income producing assets involves risks that may have the opposite of the intended consequence. That is, instead of preserving capital, they could be putting it at jeopardy.”

That has turned out to be a prescient observation. Equity income funds generally have performed worse in the Covid-19 crisis than those that do not target yield. In the UK, the average UK Equity Income fund has lost 21.2% against 17.2% for funds in the UK All Companies sector year to date, according to data provider FE Analytics. A similar performance gap also opened up during the GFC meltdown.

Meanwhile, volatility in higher-yield sectors such as property and higher-yielding bond funds has been on a similar scale to that seen in equities. 

Led by growth stocks, markets have since recovered some or all of their losses from the first quarter. The fact that growth has led the recovery in the depths of a global economic crisis is another good reason for investors to consider adjusting portfolios to focus less on “natural” income and more on total return. 

Plenty of actively managed funds and trusts have a total return focus – even UK Equity Income funds such as Threadneedle UK Equity Income, Trojan Income and Finsbury Growth & Income (LSE:FGT). It is noticeable that their headline yields were lower than average in their respective sectors before markets were struck down by Covid-19, but that has been rewarded with sector-topping performances from a total-return perspective. 

Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC), says income-seeking investors may need to consider a number of  strategies to meet their investment needs in the post-Covid world.

“For example, companies such as Capital Gearing (LSE:CGT), Ruffer (LSE:RICA) and Personal Assets (LSE:PNL) adopt the strategy of trying to preserve capital whatever the economic weather. While they may not have high yields, they have often managed to deliver positive returns at times when markets have fallen.”

Globally invested trusts such as Bankers (LSE:BNKR), F&C Investment Trust (LSE:FCIT) and Alliance Trust (LSE:ATST) are among the many that target growth of both income and capital. Their revenue reserves are a unique benefit, allowing them to save some income in good years to boost their dividends to shareholders in leaner ones, says Brodie-Smith. “Bankers and Alliance have increased their dividend every year for 50 years and F&C has increased its dividend for 49 consecutive years,” she points out. 

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The investment company structure also permits some trusts to pay dividends out of capital profits. For example, International Biotechnology (LSE:IBT), Standard Life Private Equity (LSE:SLPE) and JPMorgan Global Growth & Income (LSE:JGGI) aim to pay a fixed dividend of 4% of net asset value, which can be funded from capital profits if required. “This tool can be a useful way for income-seeking investors to diversify and receive dividends from sectors not normally associated with income,” says Brodie-Smith.

Investors who focus on higher-yielding sectors end up with less-diversified portfolios and the Covid crisis has proved Vanguard’s assertion back in 2016 that such portfolios display higher levels of risk, along with an increased risk of falling short of financial goals.

Although growth is not strictly the new income, prioritising total return over income will not only play an increasingly important role in how investors, particularly retirees, access their investment returns in the years to come. It will also help to ensure a portfolio stays the distance as long as the investor.

The author was editor of Money Observer between 1998 and 2015. 

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