Why income sustainability should be the guide for navigating the new world.
One notable occurrence during the recent COVID-19 market turmoil was the underperformance of higher-yielding assets – both across and within asset classes – which contrasts with typical outperformance in previous bear markets. One of the hardest hit areas was within equities, where the government-imposed lockdown measures have halted activity – putting severe pressure on companies to cut dividends to preserve cash.
This presents a conundrum for income investors, with the reduction of these payouts forcing them to reconsider how they source yield. However, the sell-off has created some of the best risk-adjusted return opportunities – across equities and bonds – that we've seen in years. Navigating this new world won't be easy – and is a long-term journey. We believe the winners and losers will be separated by factors of sustainability (of income), which relies on the fundamental quality of the companies in a portfolio.
Dealing with dividends
Why are dividends being cut? In an economic crisis of this size, liquidity is key, with companies desperate to preserve cash as a balance sheet buffer. Dividends are often the first port of call, and while this is understandable, it doesn't bode well for income investors reliant on these payments.
But we think there's a fundamental problem with dividend-hunting, which may have left investors unnecessarily exposed to dividend risk. Indices like the S&P 500 Dividends Aristocrats – a global index of the highest dividend stocks that have maintained their dividends for ten years – is often cited as a good source of quality dividend payers. However, many companies will often take on additional leverage to maintain those dividends, rather than these distributions being based 'natural profitability' generated by robust business models. Unfortunately, this spike in dividend risk facing income investors will continue for many months as companies adapt to the new world.
Avoiding over-leveraged companies and any signs of creative accounting is crucial. The focus needs to be on bottom-up fundamental research with a laser focus on a company's profitability and capital allocation decisions across their supply chains. At Ninety One, we have a concentrated portfolio – tens rather than thousands – because we want to have full understanding of what's in our portfolios at any given time. The result is a highly differentiated portfolio of stocks compared to traditional dividend indices, which gives us more confidence that the assets we hold will continue to provide the risk-adjusted returns we're seeking.
Valuations were transformed after the COVID-19 crash. But, with the unprecedented response from governments and central banks, the amount of liquidity which flushed the market resulted in rapid stabilisation. Now, the yield on our investible universe is the highest we've seen in several years.
In the aftermath, corporate bonds presented the most attractive opportunity, as the forced liquidation of many portfolios during the sell-off led to underperformance. This led to yields increasing significantly, prompting a rally as markets stabilised. In particular, we believe many high-quality investment grade companies have been unfairly sold off, creating very attractive risk-reward opportunities. We also see selective opportunities in high yield debt, listed infrastructure and across equities.
The transformation has been sudden, however the uncertainty has generated new opportunities. A patient approach is crucial; while headline yields may appear attractive, investors must do their research to uncover those long-term opportunities which can offer sustainable incomes and thereby meet their risk-adjusted return goals.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor's home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.