Income investors should look beyond Britain to beat the cash squeeze

Dividend cuts by FTSE 100 companies won’t be repaired quickly – many firms were already living beyond their means. Investors should diversify abroad for sustainable high yields, says Cris Sholto Heaton.

By Cris Sholto Heaton

published 14 May 2020

in Features

The outlook for income investors just keeps getting worse. Last week telecoms firm BT became the latest high-yielding British stock to suspend its dividend. A fortnight ago oil major Royal Dutch Shell reduced its payout by 66%, the first time it has cut since 1945. Taking these into account, UK firms have now reduced, suspended or cancelled around £40bn in dividends since the beginning of the coronavirus crisis – amounting to more than 40% of what they were expected to pay this year.

Overall, dividends for 2020 could fall by 53% in a worst-case scenario, reckons Link Group, which looks after the shareholder register for many of the UK’s largest firms. Since those projections include £18bn in dividends paid before the coronavirus crisis peaked, the looming cash crunch for the rest of the year is even worse than these headline figures suggests – out of £82bn previously expected between April and December, just £30bn (36%) still looks entirely safe.

Whether dividends will rebound next year is uncertain. If you look at the dividend-futures market, traders appear pessimistic. Dividend futures are a derivative whose value depends on the amount of dividends that are eventually declared in a future year – so the ultimate value of the FTSE 100 December 2021 dividend futures contract will depend on the total amount of dividends declared by members of that index in the 2021 calendar year. Current prices for these contracts on Intercontinental Exchange imply that total dividends for 2020 will be down by almost 50% from last year and will then fall a further 10% or so in 2021. They will not even come close to regaining past highs by 2026, which is the last contract currently available for trading.

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It’s important to note that the market value of these contracts reflect traders’ forecasts for what will happen to dividends – and we all know that forecasts are not hugely reliable. What’s more, liquidity in more distant contracts is pretty low – in fact, there is only significant amounts of trading in 2020 and 2021 contracts in most cases. Finally, because each contract doesn’t settle until after the end of the relevant year, they should trade at something of a discount to the value of the dividends the market expects – ie, longer-term contracts will trade at a much steeper discount to allow for the fact that it will be years until the buyer gets paid and for the high level of uncertainty over how much the payment will be.

Obviously, the outcome will depend partly on the strength of the economic recovery – if we have a rapid, V-shaped rebound, dividends will come back faster. That could happen if we quickly find more effective treatments for Covid-19, or develop and scale up a vaccine sooner than expected, or find that a combination of sustainable changes to how we work and live, combined with moderate levels of immunity in the community, makes it a manageable medium-term problem. However, there is a strong argument that even if the economy rebounds rapidly, UK dividends are not going to recover in the same way.

The FTSE 100 has had an unusually high dividend yield by global standards for quite a while. That’s partly because it has a high proportion of cyclical sectors: these tend to pay large dividends in good times, but need to cut when the cycle turns and so they trade on lower valuations to reflect that. However, a growing number of firms had dividends that would be slow to grow at best and increasingly unsustainable at worse. Among the ten largest dividend payers before the crisis hit, the average dividend cover – the amount by which earnings exceeded dividends – was just 1.4. That doesn’t provide much of a cushion.

This crisis has provided the necessary excuse for management to cut their dividends and rebase them at a level that may be more sustainable for the long term without angry shareholders calling for their heads. Those firms cannot and will not rush to restore their previous payouts when the crisis passes. In fact, management have something of an incentive to resume dividends as low as possible so they make themselves look good by growing payouts over several years.

That said, right now Europe looks only modestly more promising. Dividend futures for the Stoxx 50, traded on Eurex, predict a fall of 33% this year and 8% the following year. Many European stocks also have the disadvantage that withholding taxes on dividend income are quite high – so a 3% yield on a Swiss stock is cut to under 2% when the Swiss government holds on to 35% of that. You can claim a portion of this back, but many countries make it as bureaucratic as possible and it’s not always possible with stocks held in an individual savings account (Isa) or self-invested personal pension. I hold quite a few European blue chips in my own portfolio – but this is the biggest drawback with many of them.

US dividends are forecast to be cut less – 13% per year in 2020 and 2021. US withholding tax is just 15% for UK taxpayers so long as you complete a W-8BEN form every three years (a simple process through your broker) and that falls to zero for stocks held in a Sipp. But US dividends are low – the S&P 500 has a yield of just 2%. Company managements tend to favour share buybacks instead of dividends as much as they can (see page 13). I’ve kept many high-quality US companies as long-term holdings – but this is the world’s most expensive major market and so there are very few firms that offer obvious value as an income investment right now.

The best option for diversification and growth is Asia – notably Hong Kong and Singapore, which benefit from no dividend withholding tax. I wrote about the opportunities in this part of the world in early February. Since then, shares have got cheaper, yet dividends look like they should hold up much better than the UK. Dividend futures for Hong Kong’s Hang Seng index forecast a 20% drop in 2020, but much of that is due to HSBC suspending its dividend under pressure from UK regulators. The price of the 2021 contract suggests a modest rebound next year.

There are short-term risks: many of these countries are currently leading the world in dealing with Covid-19, but we can’t be certain that will continue. Their economies cannot avoid being affected by the collapse in demand in the rest of the world. And in the medium to long term, it’s unclear what the geopolitical and economic impact of the crisis will be – we must expect the focus on supply-chain security to bring some manufacturing back to Western countries in sectors such as medicine. There are also individual risks: Hong Kong’s political crisis has been out of the headlines for obvious reasons, but as the coronavirus passes, protests will resume. It’s just a matter of how bad the situation will get.

Still, for most of the companies I profiled back then, the investment case has been little changed by the coronavirus crisis and likely dividend cuts are limited. Investors should hopefully get a reasonably solid yield of around 5% from a portfolio of stocks like these – either by investing directly or by holding an investment trust such as Aberdeen Asian Income (LSE: AAIF). This is a fairly conservative fund that is invested in many of the firms below. It yields 5.4% (although this might fall a little this year) and trades on a discount to net asset value of about 12%.

Take the Singapore real estate investment trust (Reit) sector, where some of the big Reits that are ultimately backed by government-linked companies offer a solid cornerstone to a portfolio: Ascendas Reit (industrial), CapitaLand Mall Trust (retail) and CapitaLand Commercial Trust (offices). They now yield 5.5%, 6.5% and 5.2% respectively. However, the rental income will inevitably be affected by the crisis to some extent. Some tenants may go bust, others may need to defer their rent (the Singapore government has introduced rules to suspend eviction of commercial tenants over the next six months). And the Reits may take advantage of easements allowing them to delay distributing some of their income to shareholders, to help conserve cash at this uncertain time.

Nonetheless, Ascendas Reit’s dividend looks solid at present. CapitaLand Mall Trust and CapitaLand Commercial Trust said in their first-quarter results that they are holding back some distributable income as a precaution (although this would not be paid until after the second quarter anyway) and it’s probably prudent to assume that they will suffer a 15%-20% decline in overall payout for the year – but I’d expect that to rebound when the crisis is over. Their planned merger to create a combined office-retail Reit is on hold, but seems likely to go ahead in due course.

The outlook for Singapore’s banks – DBS (6.5%), OCBC (5%) and UOB (5.5%) – has become a little more uncertain, due to both the coronavirus crisis and the collapse in the oil price (all three had meaningful exposure to the spectacular collapse of a major oil-trading firm). Nonetheless, Singapore’s banks maintain high capital ratios and are as well placed as any to weather this crisis. DBS has already said it will maintain its first-quarter dividend, OCBC and UOB are likely to do so for their first-half dividends.

HSBC’s decision to suspend its dividend principally reflected the situation in the UK. However, Hang Seng Bank (not one of my suggestions last time), which is majority owned by HSBC, also cut its first quarter payout by 20% after the Hong Kong regulator urged banks to conserve capital. So while Bank of China Hong Kong (6.4%) suggested at its full-year results in March that it would be able to maintain its current payout (which was twice covered by last year’s earnings), there has to be a question mark over it. It would be prudent to assume a similar cut is possible – which is still much better than banks in the UK.

Hong Kong-listed China Mobile (5.6%), the largest mainland telecoms firm, only pays out around 50% of its earnings in dividends at present. HKT Trust & HKT (5.8%) and Singapore Telecommunications (6.4%), the leading operators in Hong Kong and Singapore respectively, have both indicated that they will maintain dividends this year. That said, like many telecoms, they are paying out essentially all their earnings in dividends. The threat of rising competition together with increased capital expenditure on new capabilities such as 5G mean one can’t be entirely comfortable with these dividends in the medium term (the fact that StarHub, Singapore’s second-largest operator, did not commit to maintaining its dividend at the current level in its first-quarter results was a reminder of that) – but these risks are reflected in the share price. The yield might be trimmed, but it shouldn’t collapse.

Conglomerate Swire Pacific (6.2%) says it will report a loss in the first half of the year due to the impact of the coronavirus crisis on Cathay Pacific, its airline arm. The dividend was maintained for the year just finished, but no decision has been made for the next interim dividend. Aviation is a notoriously dreadful business at the best of times, but this crisis has exceeded the worst expectations of even the most experienced investors (notably Warren Buffett, who lost billions on his investment in US airlines). Meanwhile, Jardine Matheson (3.9%) has warned that first-half profits will be significantly lower. However, its dividend is conservative – it pays out well under half its earnings – so I struggle to see it cutting in anything but the most extreme scenario.

Still, given the scale of the dividend cuts that are coming, investors must be aware that while trusts’ reserves can prop up payouts this year, that will be the limit in some cases. Troy Income & Growth this week said that it would use its reserves to maintain its third- and fourth-quarter dividends, but warned that it would reduce its payout next year. It has one of the lower levels of reserves among equity income trusts, so this should be little surprise – but even those with the biggest buffers are facing unprecedented cuts within their portfolios and the more they struggle to maintain dividends this year, the bigger the cut might have to be in 2021. So you can’t just buy these trusts and hope for the best – you need to be aware of how the outlook for UK dividends is evolving and what that might mean for the stocks that the trust owns.

The crisis has also shown the value of lower-yielding stocks with more defensive dividends that can be grown modestly in good times and maintained in bear markets. The safest dividends are probably firms such as Reckitt Benckiser (LSE: RB) and Unilever (LSE: ULVR), despite relatively modest yields of 2.5% and 3.5% respectively. Even traditional sectors such as alcohol are being affected by the closure of pubs and restaurants, although Diageo (LSE: DGE) and its 2.5% yield seem safe enough. The sustainability of dividends at AstraZeneca (LSE: AZN) and GlaxoSmithkline (LSE: GSK) has long been questioned by some investors, but this crisis should play to their strengths.AstraZeneca has rallied rather strongly and now yields just 2.5%, but Glaxo is on 4.6%.

Finally, some of the recent cutters might deliver pleasant surprises with how much of the dividend is restored when the crisis is over. It’s too early to be sure, but for once some of the banks could deliver – most obviously HSBC (LSE: HSBA) if it can benefit from the strength of its Asian business. Having reset its dividend radically, Royal Dutch Shell’s (LSE: RDSB) 4.1% yield may be quite attractive. By contrast, it’s hard to see how rival BP doesn’t ultimately cut a payout that now stands at almost 11%.

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Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.