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Where do investors go in an income drought?
YOU don't have to be drawing income to understand the power of compounding and the importance of having a reliable income stream within your portfolio. Covid-19 has made life harder for already yield-starved investors, and each asset class faces its own challenges.
With dividend income such a core staple of investors' portfolios, let's look at the equity picture first. Around US$2 trillion was committed to dividends by listed companies worldwide in 2019. Since then, there have been headlines on dividend cuts, suspensions and withdrawals across a variety of sectors. The 10 largest companies in the FTSE 100 are responsible for almost half of the UK stock market's dividends: one third of that stream has been lost and several others moderated.
Some companies are simply responding cautiously to what economists say could be the deepest recession on record. Others - like European and Australian banks - have had decisions taken out of their hands, as regulators have called for dividend freezes to strengthen balance sheets.
Balancing capital efficiency and resilience is also causing a rethink among companies. Before Covid-19, accessing ultra-cheap debt to maximise pay-outs fuelled distributions; particularly in the US, where share buybacks reached record levels. This strategy could prove costly, as those that returned more to shareholders than they generated in free cashflow have found themselves with less cash, more debt and are less prepared for the downturn.
Focus on long term
At times like these it can be difficult to focus on the long term, but it is worth remembering that there are still companies positioned to benefit from secular growth trends. There has been standout performance from digital infrastructure, for instance, where companies operating data centres have reported record levels of activity as companies migrate activities online. As global data creation is expected to compound at more than 25 per cent a year until 2025, this is a theme with real momentum. Certain semiconductor producers, for example, which make everything from smartphones to cars and are considered to be essential businesses, have been able to operate through the lockdown.
Elsewhere, companies with defensive characteristics - in healthcare, utilities and consumer staples - also look well placed. Overall, around 40 per cent of global dividend payers fall into this category, so the opportunities are diverse, and many have unbroken dividend growth records going back decades.
Energy stocks have historically been big dividend payers, making them a favourite among income investors. They have been reluctant to make cuts, despite sharp reductions in energy demand and short-term profitability. Royal Dutch Shell's historic dividend cut, its first in 75 years, has understandably caught attention. Many of its peers in the oil and gas sector are expected to come under material stress, but time will tell whether the market ultimately places a higher premium on dividend track record over operational resilience.
EMD: A widening gap between winners and losers
It is not just equity income that is feeling the effects of the Covid-19 shock. The higher yields available on emerging market debt (EMD) have historically been attractive to income investors. However, the elevated yields on offer must be considered against a weakening outlook, as the deterioration in fiscal balances and reduction in cross-border trade may lead to credit events for some issuers.
Despite this, attractive opportunities exist in select countries and companies where credit metrics are likely to be able to withstand short-term weakening. Among the better placed sovereign issuers is Ukraine, which is pressing ahead with reforms that will unlock further IMF funding. Ivory Coast and Kenya have also been relatively swift to adjust budget spending and make financial projections available.
It is also worth noting that fundamentals for emerging market corporates have improved over the last couple of years and compare favourably to developed market issuers, with lower net leverage, higher interest coverage and higher cash levels. Default rates will increase but are likely to be significantly lower than in EM sovereign issuers - and perhaps even lower than in developed market corporates.
Overall, the differentiation within the universe is becoming more pronounced. Selectivity has always been key in emerging market investing, but never more so than now.
Sustainable, real income
Infrastructure can provide a defensive foundation in a portfolio. Perhaps unsurprisingly, sectors showing greater resilience include non-discretionary services like power and utilities. Data transmission and storage assets also have utility-like characteristics, just like water or power networks, as data access has now become an essential public service.
Conversely, there has been greater uncertainty in sectors experiencing major demand shocks; in transport for example (airports, toll roads, motorway service stations and ports.)
The resilience of infrastructure debt will be tested in the coming months. In the past, the debt has experienced less rating migration and lower credit losses than in equivalently rated corporate credit. While sudden revenue reductions may result in some technical defaults, liquidity will be key to prevent any payment defaults or debt restructurings. A few sponsors are being proactive and engaging with lenders early and acting quickly to assess how to manage any income shortfall. However, this approach is not widespread.
Long-income real estate
Long-income real estate is one sector that has historically performed well in difficult periods; benefiting from recurring, contractual leases that are less economically sensitive than other sectors. In past corrections, like the one in late 2018, listed property also outperformed global equities by a solid margin.
With Covid-19, the response has been different so far, with the global real estate investment trust market markedly underperforming. By changing the way in which physical space is used, it has accelerated some structural changes that were already under way and altered the underlying income drivers.
For assets let to high quality counterparties - like those in the public sector - the income outlook is broadly positive. Long-lease supermarkets also look well-placed, as 'stay at home' orders have increased demand for groceries.
Ultimately, we expect to see significant changes in a number of sub-sectors. In logistics, occupiers may seek to boost supply chain resilience and hold more inventory, which would be positive for demand. In offices, the shift towards home working might accelerate; we are also mindful of challenges in retail, where weaker retailers in secondary locations may not return at all as the shift to online retail accelerates. Impacts will depend on specific local factors, including the size and nature of stimulus and the type of recovery we see.
As with the financial crisis, the economic fallout from Covid-19 will lead to a reassessment of investment risk. But, with absolute yields once again languishing near historic lows, demand for income will persist.
Covid-19 has introduced much greater complexity into the search but drilling into the detail reveals that there are opportunities in various asset classes, some more unexpected than others. With careful management, it is still possible for investors to construct a resilient income stream - so long as they are prepared to cast the net more widely.
- The writer is fund manager, sustainable income & growth and head of listed real estate at Aviva Investors