It has been a difficult time for those looking for an income from their stock portfolio. Some of the key dividend paying sectors, such as financials and telecoms, have been unloved, with markets led higher by a relatively narrow group of high-earning but low dividend companies.
The reasons behind this preference are easy enough to understand. Interest rates are rising in the US and government bond yields are edging higher as a result. Having hit lows of below 1.5% in 2016, the US 10 year treasury now yields almost 3% (1.). This creates a more difficult environment for income-paying shares.
Specifically, some of the most reliable dividend paying companies had benefited from low interest rates: income-seeking investors who would normally have turned to the bond market could only get an inflation-beating income in the stock markets. As bond yields have risen, those same investors no longer need to take risk in stock markets to get income and can scuttle back to bonds. This has hurt certain ‘bond proxy’ equities.
There is also the problem that many of the UK’s key dividend paying companies tend to be large, internationally diversified companies. This would normally be a good thing, particularly as it leaves them relatively immune to the problems around Brexit, but it does mean they are vulnerable to concerns around future trading relationships. President Trump is busy re-writing international trading agreements and some of these companies have suffered in the cross-fire.
The question is what happens from here. First, we would note that although interest rates are rising in the US, there is little impetus for them to rise elsewhere. While the Bank of England still hopes that the economy remains sufficiently resilient for them to raise rates in August, lower inflation, weakening wage growth and lacklustre retail sales are making it tougher for them to do so.
The UK 10 year gilt has actually declined since the start of the year and now sits at 1.2% (2.). This means UK investors still have to take equity market risk to achieve an income above inflation. Inflation may have dropped, but it remains well above 2% (3.)
With this in mind, at Shires Income PLC, we believe the rush out of some of the more stable dividend paying companies may have been premature. These companies still offer a reliable income above inflation and the situation in the US is not the same as the situation elsewhere. Yes, a full-blown trade war remains a significant risk, but we believe this worst-case scenario is still unlikely.
At the same time, the income available from the UK stock market is healthy. The 3.8% dividend yield on the FTSE 100 outpaces all other major economies by some margin (4.). Admittedly, there has been a tailwind from the weaker sterling, but this effect has weakened more recently. FTSE 100 companies are forecast to pay £90.4bn in dividends this year, up 2.9% on last year (5.)
There are undoubtedly some vulnerable areas. UK retailers may not be over the worst as shoppers choose their laptops over the high street. Equally, some of the government contractors may be forced to cut their dividends if Carillion’s weakness is replicated elsewhere. At the same time, there are well-flagged macroeconomic and political concerns that continue to weigh on the UK.
However, investors should also focus on the resilient cash flow and earnings of many UK dividend paying companies. The oil price is improving, which should provide strong support for the oil majors. Many of the telecoms companies have seen their share prices dip, leaving them on discounted valuations with high yields, while the outlook for their businesses is little changed. It is a similar picture for the financials, where a falling share price has left their yields looking attractive.
That said, while we believe these stable businesses will prove a compelling choice as the environment shifts, we would also not neglect the significance of growth potential. Global economic growth continues to power ahead, and even if higher rates are not a problem today, we need to consider their influence in future.
With this in mind, with Shires Income PLC, we aim to ensure that companies within our portfolio have the ability to grow ahead of inflation. This needs to be stable and have the potential to compound over many years. We have a holding in the Aberdeen Smaller Companies Income Trust PLC. We believe smaller companies are a good way to generate growth over time.
We believe that income-paying companies have been sold off excessively amid concern over rising rates. The real picture is different and, as such, value is emerging. In our view this is a good time to be a dividend investor.
Risk factors you should consider prior to investing:
• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
Other important information:
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