What Next for Income Investing?
- 31 May 2020
- 10 mins reading time
Incomes from investments are set to fall over the near term
Identifying income-generating opportunities requires analysis of individual companies' health
Investors will need to be patient and more careful when investing for income
To date, there have been more than five million confirmed cases of Covid-19 and a third-of-a-million deaths. Drastic measures have been taken to try to stem the human tragedy. These entirely necessary measures have secondary consequences that we need to consider. This briefing will focus on the ramifications for four types of income-generating investments.
Dividends from company shares
A company can choose to share profits with shareholders by making a dividend payment. In 2019, the average dividend payment made by UK companies as around 4.4%, comfortably above the 1.9% estimated for the US.
Since February of this year, companies have been forced to slash the dividends they pay. Even those that still have sufficient profits to pay dividends are being encouraged, in some cases required, to cut dividends and build up cash reserves to help them weather the stresses that have come about as a result of the virus. For others that have received government support, such as through furlough payments, it would be politically unpalatable to continue to pay dividends for the time being.
This has left overall global dividends being cut by between a half and a quarter compared to those being paid out in 2019 according to a recent report from Schroders. The same report also noted that this is only the second fall in dividends of more than 20% since the Second World War. It goes on to say that these dividend “recessions” tend to last longer than the slump in share prices.
This makes sense because share prices tend to reflect what investors think the future holds for a company’s fortunes, while dividends are paid out after a company’s profits have got back on course.
However, this dividend recession might be relatively short-lived. Widespread action was taken quickly and broadly which ought to support the ability of companies to bounce back.
Financial indicators support this. Futures dividends contracts allow investors to place an investment according to what they expect dividends to be. Taking these contracts in aggregate, the general expectation is for dividends to fall sharply in 2020 and more gently in 2021, before recovering in 2022 by around 10% in the US. The US tends to be the leading economy among developed countries so, if this pattern were to be repeated in the UK, it could indicate a relatively short-lived dividend recession. What’s more, with UK dividends being cut from a relatively high level, remaining dividends might still be fairly reasonable.
But this isn’t a one-size-fits-all situation. Investors will have to be more selective when choosing which companies are likely to be able to offer sustainable dividend payments.
When looking at potential income-investment targets, we are focusing on companies that we believe are most appropriately positioned to come through the crisis without having to fundamentally change their long-term business plan.
Companies involved in the oil industry are facing an additional challenge.
The price of a barrel of oil touched $140 in 2008 and has been well below that number ever since. In 2016, concerns relating to over-supply pushed the price down to below $30. This meant that major oil-producing companies had to implement cost-cutting efficiencies.
Since then, supply and demand for oil stabilised allowing it to trade between $50 and $70 until 2020 when two things happened.
Firstly the pandemic took hold, requiring a global lockdown which shut factories, reduced transport and crushed demand for oil. Secondly, after failing to agree reduced supply levels with other oil producers, Saudi Arabia substantially increased its supply of oil in order to push oil prices down and heap pressure on other countries. Other oil-producing countries cannot produce oil as cheaply as the Saudi Arabians can.
This double-whammy for oil-producing companies has consequences for two types of income-generating investments: dividends and corporate bonds.
Obviously dividends are being cut. Shell has cut its dividend for the first time since the Second World War. But oil majors like Shell, had already cut costs so were partly prepared for an event like this. What’s more, these big players often own everything from the oil well to the petrol station, making them less vulnerable to oil price cuts imposed by another major player.
The second type of income-generating investment involves a less obvious consequence relating to corporate bonds.
Many of the smaller companies in the oil industry, such as drilling or engineering specialists, need a substantial upfront investment before they can drill or sell their wares. This investment often takes the form of bonds that the company sells to investors. Those bonds can come with quite a high risk rating because there’s no guarantee that the company will hit oil or sell lots of engineering products or services.
The higher the risk rating, the higher the yield has to be on those bonds to compensate investors for the increased chance that their investment might not pay off.
Right now, profit margins are being squeezed, companies are in lockdown, there’s more oil sloshing about than people need, but these companies have substantial debt obligations that they have to meet.
Investors need to manage how much risk they can afford to take. For an increasing number of corporate bonds issued by oil-related companies, the income-payment isn’t high enough to justify the risk.
But the same does not apply to all corporate bonds.
Governments and central banks have been fast and generous in their actions to provide financial support to companies and households during the lockdown. As a result, companies without the extra impediment of oil-related troubles might be reasonably placed to maintain their debt obligations.
The demand for and prices of corporate bonds suffered along with equity prices during the height of virus-related concerns during March. Since then, they have only partially recovered, despite the financial support being offered. Our analysis suggests that there are some attractively priced income-generating corporate bonds (subject to considerable research into the relevant sector and respective company’s financial stability).
The outlook for government bonds is slightly different. A sovereign issuer such as the UK government, has yet to default on its bond obligations. As a result, the risk level associated with UK government bonds or “Gilts” is low. As mentioned before, the lower the risk-rating, the lower the payment to investors tends to be.
What’s more, interest rates have been extremely low for many years, so the UK government doesn’t have to offer a particularly high annual payment on bonds (the coupon) in order to attract investors away from other low-risk rated income-generating opportunities such as a deposit account.
With interest rates set to remain low for the foreseeable future, the chances are that Gilt yields will also remain low, even after the government issues billions of pounds-worth of new bonds to pay for the financial support that it has pledged during the lockdown.
The unavoidable conclusion as we see it, is that there will be a short- to medium-term drop in the income generated by the sort of investments we’ve considered.
We anticipate that this unpleasant situation is likely to last for between two and four years. After that, our analysis suggests that incomes could start to recover subject to two provisos:
1. There isn’t a second wave of the pandemic sufficient to repeat the lockdown requirement
2. Governments and central banks continue to support businesses and households, enabling the economy to recover and incomes to be generated.
At this difficult time, some people may consider cashing in some of the investments that they hold. Every investor’s situation is unique, so it’s impossible to provide general guidance for that. Instead, here is how the Pensions Advisory Service responds to such a consideration, “The most important thing is not to panic and make rushed decisions... if you're looking for specific advice on which option, product and provider you should choose then you can always take regulated financial advice.”
 Source: Worldometers.info, 21 May 2020.
 Source: “Dividend yields by country”, Siblisresearch.com, accessed 21 May 2020.
“Dividend bear markets: the grizzly facts”, 19 May 2020
 “Dividend bear markets: the grizzly facts”, 19 May 2020
 Source: “Coronavirus - how will this affect my pension or investments?”, accessed 21 May 2020, www.pensionsadvisoryservice.org.uk
Any views expressed are our in-house views as at the time of publishing.
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Forecasts of future performance are not a reliable guide to actual results in the future; neither is past performance a reliable indicator of future results. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment,
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