How to shield your portfolio from dividend disaster

As the coronavirus shutdown hammers corporate earnings, many dividends have been cut or face being suspended. John Stepek explains what to do if you’re looking for steady dividend income.

The coronavirus shutdown is hammering corporate earnings. As a result, dividends across various sectors have either already been slashed or are at high risk of being suspended.

So what can an income-hungry investor do about it?

Why we like dividends

We like dividends at MoneyWeek. You can get caught up in all sorts of arguments about dividends versus share buybacks, and both sides often have good points. But the reason I like dividends is that they are very hard, if not impossible, to fake.

Share buybacks can come and go, they can be paid out of borrowed money, and they can be used to fiddle executive compensation packages. You can see why managements might favour them over dividends.

Dividends, on the other hand – once investors get used to a dividend, they expect to get it, assuming all else is equal. That puts pressure on management to remember the shareholders – to remember who is their ultimate boss. It also puts pressure on management to make sure the money is there.

I really don’t think the value of that discipline can be underestimated.

That said, when times are hard, sensible shareholders understand that sometimes the dividend has to be put on hold, cut, or ditched altogether. And right now is one of those times.

Very few sectors are not at risk. You need only glance down a list of the highest-yielding stocks in the FTSE 100 to see this. About a third of Britain’s biggest companies are trading on yields of more than 6%.

How many of those are going to be paid out? I wouldn’t like to hazard a guess at the moment but you have to believe that anyone in the travel sector (airlines, cruises, hotels have all shut down), the oil sector (prices have crashed), the mining sector (prices have mostly crashed), financials (investors are pulling money out which means lower fees), and housebuilding (the property market is on hold) – and that’s just at a glance – are all on the “potential dividend cut” watch list.

We’ve also got a lot of pressure now on the UK banking sector to suspend its dividends following the example of the eurozone (UK banks are in better shape than those in Europe but this is politics and banks are still in the bad books after 2008).

As far as I’m concerned, if a dividend is suspended for political reasons, then I’m not too worried about it. For example, if you think UK banks are a “buy” right now, there’s no reason to change that simply because the regulator might stop them from paying their dividends.

That money isn’t going anywhere. Assuming that their prospects are identical, save that they can’t pay out the dividend mainly for political reasons, then it’s not a problem. Better yet, they might be forced to cut bonuses too, which is even more money for shareholders (OK, I admit that my tongue may be gently lodged in my cheek as I type that).

It’s very hard at this stage to tell who’s most likely to be safe and who isn’t – which means it’s tough to decide whether that juicy double-digit yield is an opportunity or a sign that it just won't be paid – but, in short, while a fair few dividends have already been cut and share buybacks suspended, there’s probably more to come.

The best bet if you are looking for dividend consistency right now

Of course, none of this helps you if dividends are the cornerstone of your investment world. I would urge you not to neglect capital growth as a source of income – not all of your income has to come from actual “income” – but I also appreciate that changing the habits of a lifetime can be tricky.

So if dividends are what you’re after, take a look at the investment trust sector. One benefit of investment trusts is that they can hang on to income during decent years, and then pay it out at times like this. They can even pay dividends out of capital if necessary. In other words, they can smooth their dividend payouts.

Obviously, that money has to come from somewhere and you have to make sure that the trusts in question are managing it sensibly. But if this is to be a short-lived collapse rather than a long-term decimation of dividends (fingers crossed), then having the ability to get investors over this hump looks very handy indeed.

Conveniently enough, Alan Brierley and Ben Newell at Investec just put out a report on the UK Equity Income Sector. They point out that even in the aftermath of 2008, 11 out of 14 UK equity income trusts actually increased their dividends, while only one took a cut (and even that was only 7%).

The average yield in the sector is now roughly 6%. That’s very appealing. So can these trusts afford to keep paying these yields?

Brierley and Newell assume a 30% fall in income in the first year. That may or may not be overly optimistic but at this point that’s roughly what UK dividend futures are pricing in (dividend futures are effectively bets on what’s going to happen to dividend payouts). It’s also worse than the hit the sector took during the financial crisis.

Under that scenario, all of the 14 trusts examined can keep paying the dividend out of their reserves (and that includes a 3% hike in the dividend). If there were to be a further 30% drop in income during the second year, more than half would still have sufficient reserves – even assuming another 3% rise in dividend payouts.

In short, if you’re looking for steady dividend income, then UK equity income investment trusts are probably a good place to go. On top of that, in terms of track record, several trusts have long histories of raising dividends which they almost certainly won’t want to break.

Three of the trusts – City of London (LSE: CTY), JPMorgan Claverhouse (LSE: JCH) and Murray Income (LSE: MUT) (NB my colleague, Merryn Somerset Webb, MoneyWeek’s editor-in-chief, is a non-executive director of the Murray trust) – have paid out rising dividends for more than 40 years in a row (and 53 in the case of City of London). All three currently yield more than 5%.

None of this is to say that these trusts specifically will suit you. And as I already mentioned, don’t fixate on dividends to the point where you neglect capital growth. But if you’re looking for yield, this is a good place to start researching further.

In the next issue of MoneyWeek magazine (out on Friday), our regular columnist Max King will be looking at some other investments that have proved resilient in the face of coronavirus so far – and whether they are still worth buying at this point. If you’re not already a subscriber, get your first six issues free here.

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