How to build a secure income portfolio

The coronavirus-induced collapse in dividends has highlighted a huge problem with the UK stockmarket for investors that rely on it for income. A relatively small number of sectors and stocks have become a very large component of total dividends: banks, insurers, energy and resources together accounted for more than half of UK dividends a year ago, according to data from Link Group, which maintains the shareholder register for many large UK firms.

With companies large and small cutting payouts to preserve cash, the headline figure for 2020 is set to be grim. Regular dividends will be down by around 40% year on year – possibly almost 50% if you include special dividends, which were obviously much more prevalent last year. But the damage for many income funds may be greater. In order to show prospective investors a decent yield, they will have crowded into many of the higher-yielding stocks that have been most affected by the crisis.

Individual investors don’t need to fall into this trap. They can design a portfolio tailored to their own situation, maybe targeting a lower immediate yield in exchange for more stability or growth . And while we are by no means through this crisis, there are already some lessons to be learned about building a dividend machine that can cope with a crisis on this scale – as well as a few clues about where to look for opportunities as the recovery gets under way.

Building on the bond proxies

Traditionally, the foundation of many income portfolios would have been high-quality bonds from governments or top-rated companies. These provided a steady, reliable income to underpin higher but more volatile yields from other sources. But yields on these are tiny or even negative, unless you’re willing to buy very long-term bonds – which would expose you to the risk that inflation rises sharply in the decades ahead, hugely eroding the real value of your income.

This makes little sense in a balanced income portfolio (although safe-haven government bonds can still have a role in an asset allocation portfolio that focuses on trying to keep your wealth steady through market ups and downs – they performed that role admirably earlier this year). That’s why investors have increasingly turned to large companies in defensive sectors with stable earnings and solid dividends – often referred to as bond proxies. 

These dividends are not guaranteed in the way that bond payments are. A company can cut its dividend whenever it wants, while it can’t just skip a bond payment. But firms like this rarely do, so a diversified portfolio should deliver a fairly consistent income. In addition, dividends would be expected to rise over time – at least in line with inflation, hopefully by more – giving them at least one potential advantage over bonds in the years ahead.

Low and steady versus high and slow

Investors’ favourite bond proxies fall into two broad categories: sectors such as consumer staples and pharmaceuticals and healthcare (which typically offer lower yields and the promise of a little more growth) and utilities and telecoms (higher yields, lower growth). Payouts from the first group have been pretty good in this crisis so far: dividends from consumer staples in the UK were down just 5% year on year in the second quarter and those from healthcare up 1%, according to the latest quarterly analysis from Link. 

We have seen a dividend cut from tobacco firm Imperial Brands, which had long been expected: Covid-19 has given management at many firms an opportunity to slash unsustainably high payouts without being singled out. This has been more of an issue in other sectors. BT followed Vodafone’s dividend cut last year, contributing to a 70% year-on-year fall in dividends for the telecoms sector. In utilities, Centrica has done the same, suspending a dividend that was already reduced in 2019, although other firms such as National Grid, Pennon and SSE have maintained their payouts.

Overall, then, consumer and pharma have delivered as investors hoped in this crisis, while the picture for telecoms and utilities is more mixed. Over the long term, I’m concerned about the outlook for utilities: the lack of growth opportunities, the vulnerability to an eventual rise in interest rates (both in terms of increasing the cost of their high debt loads and the risk that higher rates will reduce their appeal since they offer little more than a high yield), and the political dangers (Jeremy Corbyn may have been too off-putting to voters to win an election twice, but the idea of nationalising or squeezing electricity, gas and water companies is not and may well return). They have a role in portfolios that need higher yields now and the near-term risks seem low. But investors shouldn’t overestimate how safe they are. Conversely, after the recent cuts, telecom dividends may emerge more sustainable and more attractive than they have been, although they remain uninspiring businesses.

In my own portfolio, I favour consumer and pharma. You can’t get a high yield in most of these stocks: typically 2%-3% for consumer staples, but these should grow at moderate single-digit rates. Some pharma stocks yield 4%-5%, but this usually reflects ever-present concerns about impending patent expiries for key products and the implications for more limited profit and dividend growth. The key examples in the UK include firms such as AstraZeneca, Diageo, GlaxoSmithKline, Reckitt Benckiser and Unilever (plus British American Tobacco and Imperial Brands if you have no ethical objection to tobacco). 

Look abroad for more choice

However, since the aim here is a very steady income stream, you should consider diversifying widely to eliminate company risk as much as possible, which means investing internationally for additional options. There aren’t enough good firms of this type in the UK and currency effects tend to work in British investors’ favour in a crisis anyway (the pound tends to weaken, increasing the sterling value of foreign dividends). In the US, that means firms such as Coca-Cola, Colgate-Palmolive, Gilead Sciences, Johnson & Johnson, Mondelez, PepsiCo, Pfizer, Phillip Morris, Procter & Gamble and many others – the list is much longer than in the UK. 3M, although technically an industrial stock and more cyclical, has some similar traits to these – it sells a lot of consumables – and looks unusually cheap at present.

Note that if you hold US stocks in a self-invested personal pension through a stockbroker that fully reclaims US withholding tax, you can get the full dividend (otherwise you lose 15%). Since US yields tend to be lower, this is important in maximising your returns. Unfortunately, withholding tax on European stocks is more of a headache and relatively few blue chips look attractive for income for a UK investor once their governments have had their slice.

Still, the absence of big brewers in the UK might lead you to consider companies such as Carlsberg and Heineken. The latter is one of the few staples firms to suspend its interim dividend out of prudence, because drinks firms have been affected by the closure of bars and restaurants – hence it’s a bit cheaper than normal. AB InBev, the largest brewer, is groaning under too much debt, has slashed its dividend to help pay this down and is unlikely to grow it for a while, so I favour its rivals even though it has a higher headline yield. 

Other firms such as Danone or Novartis still have yields in line with the lower end of their peers when withholding taxes are taken into account; others such as Nestlé, Roche or Pernod Ricard are lower-yielding now, but are always worth having on watch for chances to buy in future.

With the foundations of a portfolio established through companies like these, investors can then look for higher, riskier yields elsewhere.

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