Yield hunting in an uncertain world

For many years, particularly in Europe, ‘risk-free’ income from government bonds has been practically non-existent, forcing investors into higher risk assets such as equities and lower grade credit in search of more attractive yields.

This problem, in the midst of a global coronavirus crisis, is about to get much worse for income seekers. In the near term, for example, our US profits model suggests that earnings are expected to fall dramatically due to businesses being temporarily closed as a result of government-mandated shutdowns. A similar picture is expected in the UK and Europe.

Typically, dividend cuts follow earnings lower during recessions, as illustrated by the third chart, over the last 30 years in Europe. This time round, investors are clearly fearing the worst, with the futures market anticipating a huge drop in European and UK dividends.

Dividend concerns are not confined to Europe; US companies are expected to cut sharply too. In addition, US companies are likely to reduce or suspend share buybacks, a popular and tax efficient means of returning wealth to shareholders by reducing the share count and boosting earnings per share.

In fact, for equity investors across the world, an additional feature of aftermath of the coronavirus crisis is likely to be companies supporting their balance sheets by choosing to issue equity rather than debt. This is effectively a buyback in reverse, boosting the number of shares outstanding and diluting earning per share.   

Concentration risk looms too

Some investors will understandably look for the companies that still offer dividends or those where dividends have suffered fewer cuts. Unfortunately this can then result in further issues – concentrating investments in just a few companies or sectors (chart below).

In Europe, for example, three sectors account for over 50% of total dividends paid out to shareholders. This can result in higher concentration risk in portfolios than individuals investing in a diversified income portfolio would want.

In addition, a number of sectors look worryingly over-stretched in terms of how much debt companies have on their balance sheets compared to history (next chart). This leads to legitimate questions about how viable a number of these businesses will be in a post-Covid-19 world.

Things are likely to get worse. The approach to managing an exit from the Covid-19 shutdowns is not yet clear and it seems likely that global businesses will be forced to adopt a more conservative financial approach to get through this period by protecting their balance sheets. As a result, more widespread cuts or suspensions to stock dividends could follow.

How should we invest for income in this environment?

Investors have two options available to them in this environment: chase a diminishing pool of developed market dividends or broaden their scope across asset classes with higher and more secure income. In the multi-asset team we prefer, and have always preferred, the latter approach.

In this environment we prefer securities with fixed rather than discretionary distributions and those that are higher up in the capital structure (so more likely to get paid) – see the diagram below. Examples in our portfolios are high quality credit, preferred securities, real estate investment trusts (REITs) and convertible bonds.

In addition, it is important to broaden the investment horizon, by looking globally for income opportunities. From an equity perspective, we believe that Asia, for example, currently looks more attractive from a yield perspective, and the continent has also come through the Covid-19 crisis relatively unscathed.

Across regions, global market sector leaders, with robust balance sheets and conservative financial profiles, also look set to benefit from increased defaults among more leveraged competitors. 

In the next chart, we summarise the yields available at the end of March in the key asset classes in which we typically invest.

Summary

The search for sustainable income in the current environment can be daunting, but opportunities are clearly emerging.

There are four key lessons this analysis shows us about investing for income in this environment:

1. A broad and diversified approach is required to avoid concentration risk
2. Tilt to quality and market leaders
3. Consider moving up the capital structure, favouring fixed as opposed to discretionary payouts
4. Expand the universe geographically and by asset class.

Looking ahead, we think that in the turbulent and uncertain aftermath of the coronavirus crisis, being nimble and fleet-footed will be the best way to protect investors’ income streams.