How to build a secure income portfolio
The Covid-19 crisis has been a huge test for income portfolios, with global dividends slashed on a scale unprecedented for more than 70 years. Cris Sholto Heaton looks at some of the lessons so far.
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.
Crisis for the cyclicals
The pain in this crisis has been especially heavy in the stocks that some investors had wrongly seen as being almost as strong as the bond proxies – those that offered attractive yields, but operated in highly cyclical sectors. Insurers, energy and resources have seen payments fall by around 50% in the latest quarter, while regulators pressured banks into suspending dividends altogether.
These were exceptional circumstances and the impact would not have been as bad in a normal recession, but it emphasises why cyclicals cannot be relied upon in a downturn, no matter how cheap they look compared with the wider market during the good times. However, after such a huge sell-off, this is an obvious place to look for firms whose dividends may be at a cyclical low or pricing in huge cuts, and may rebound well in the years ahead.
There is huge uncertainty around energy and commodity prices, but to me the top-tier oil firms – Royal Dutch Shell and BP – and miners – Rio Tinto and BHP Billiton – look like they are probably cheap on any reasonable medium-term view. Some may yet cut (I find it hard to see how BP won’t), but the market is surely pricing this in by now. When the dust settles, these are probably on a yield of 4%-5% or better, with the potential for strong (albeit cyclical) growth when commodity prices rise again. I find this theme more compelling than most other recovery-linked sectors such as banks, housing or retail, because these firms’ fortunes are geared to the global outlook for commodity prices, rather than the exceptionally murky outlook for the UK economy.
The office isn’t dead
The property sector has taken a big hit in this crisis, especially real estate investment trusts (Reits). These were widely viewed as a reliable income stream and so their cuts have been a major shock. The worst-affected sectors are offices, retail and hospitality, while others, such as warehouses and data centres, have even benefited from the growth in remote working and online shopping.
This crisis is so unprecedented that we’ve little to guide us in what will happen next, but I struggle to believe that people will stop working in offices, going to shopping centres or travelling to the extent that some wilder prognostications suggest. It may take a little while and some things will change (there will be a lot of retail casualties). But judging by the extent to which once-loved stocks in these sectors are being shunned, many investors seem to feel that it will take years until good-quality office and retail space is back in demand worldwide. In my view, that’s too pessimistic.
Hence, I’m inclined to think some Reits offer value. For example, if Land Securities, which has already announced plans to resume dividends at a lower rate in November, returned to its 2009-2011 level of payouts, it would be on a 5% yield. That’s a very simplistic way of thinking about the situation, but provides an illustration of how much gloom investors are pricing in – and suggests it might be worth taking a chance on this Reit or its chief peer, British Land.
Going for long-term growth
The most idiosyncratic part of an income portfolio is the high-growth dividend section. Most of us will agree what the safe low-yielders and the riskier high-yielders are, but will disagree on which stocks might double their dividends in just a few years. Stocks like this do nothing to boost income now (see below), but are more attractive if you’re building an income portfolio to draw on in a decade or so.
The sector with most compelling trends may be information technology, where many large-cap firms have strong cash flows and are still raising dividends. Longer-term prospects include US software firms such as Apple, Microsoft or Oracle, where starting yields are low, but cash reserves are huge and capital expenditure requirements tend to be light. Asian hardware firms such as Samsung Electronics and Taiwan Semiconductor Manufacturing have higher capex needs, but have been generating lots of cash and returning plenty of it to shareholders. Biotechnology and healthcare firms with relatively low but increasing payouts – in contrast to the mature pharma companies that already pay out a large share of earnings – may also be interesting; among my own holdings, I’d put Amgen, Novo Nordisk and Novozymes in this category.
Three more options for 5% yields
Direct investment in corporate bonds is difficult for individual investors because most bonds trade in large minimum amounts. The London Stock Exchange runs a platform called the order book for retail bonds (Orb), on which a selection of corporate bonds are issued and trade in sizes suitable for most individual investors. But a look at current yields shows the challenge investors face in trying to get a higher income from bonds.
Your choice among low-risk issuers ranges from less than 1% to lend to various utility companies for two or three years, up to about 2.9% on an HSBC bond that doesn’t mature for 13 years. You’re taking on quite a lot of interest rate and inflation risk on a bond that long, without much more immediate income than you’d get from a diversified portfolio of consumer staples and pharma.
There are, of course, higher-yielding bonds on Orb, but they are significantly riskier, especially at a time like this. If you’re willing to take on that kind of risk, I’d instead favour an ETF such as iShares Fallen Angels High Yield Corp Bond GBP Hedged (LSE: WIGG), which invests in bonds that have been downgraded from investment grade (known as fallen angels). This part of the credit market historically has the strongest long-term returns, because forced selling by managers who can only hold investment-grade bonds sometimes makes these downgraded bonds unduly cheap. Its yield-to-maturity of 4.75% compares favourably with the individual issues available on Orb. (However, it’s important to note that we don’t know how bad defaults will be in this recession, so the risk is that bond losses turn out to be greater than usual.)
The demand for income has meant rapid growth in the alternative income funds sector in recent years. I’ve invested in a few at various points – from aircraft leasing to reinsurance to secured lending – and results have mostly not met expectations. In many cases, it’s been tricky to form a clear view on what the risks are and whether the higher yields compensate for them. Many are now having a dreadful time in this crisis and the outcome may give us better insight into the long-term prospects of various niches. In the meantime, none of the exotic ones stand out amid such uncertainty. But the well-established listed infrastructure funds such as HICL Infrastructure (LSE: HICL) and International Public Partnerships (LSE: INPP) are better tested and offer yields around 4.5%-5%, with a history of modest growth.
Lastly, dividends from many Asian companies are holding up better than those in the UK, Europe and the US so far, in part because many of these countries are handling the coronavirus crisis better. They should also have stronger long-term growth prospects. I’ve mentioned two leading companies above in the context of the tech sector, but a well-run Asia-focused income investment trust should hopefully deliver a yield of around 4%-5% this year, even allowing for some underlying dividend cuts and delays. This assumes that they can dip into revenue reserves that many investment trusts have built up to allow them to smooth out dividends through the economic cycle. Aberdeen Asian Income Fund (LSE: AAIF) yields around 4.8% if the current dividend is maintained and trades on a discount to net asset value of 13%.