Will your income fund be forced to cut its dividend?
The recent travails of dividend-paying stocks such as AstraZeneca and Provident Financial have highlighted the risks that income investors are exposed to.
Both companies were very popular with income seekers, but Provident Financial has scrapped its interim dividend and there are question marks over AstraZeneca’s ability to maintain its payments to shareholders.
This comes at a time when “dividend cover”, the degree to which companies’ profits exceed their dividends and therefore an important safety margin, is falling.
“Investors or fund managers who rely on a handful of stocks to provide an income stream are playing a dangerous game,” said Joshua Ausden, head of client investment strategy at Neptune Investment Management.
“Dividend cover is at its lowest level since the financial crisis, valuations are high and the UK economy is facing huge headwinds in the face of Brexit.
“If savers are investing in UK equity income funds for a steady and hopefully growing income stream, they need to be aware of these risks and understand what kind of fund they own.”
And the risk is high. Investors who own a stock that cuts its dividend face a double whammy of the reduced income payment and a fall in the share price when the cut is announced.
Who is at risk?
Dividend cover is a measure of a company’s ability to pay dividends and is calculated by dividing profits after tax by the expected dividend.
A dividend cover of two means after-tax profits are twice the dividend payout, a comfortable margin of safety. But dividend cover of less than one indicates that a company does not have sufficient profits to pay the dividend and will have to sell assets, use cash stockpiles or take on debt to make the promised payment. Otherwise the dividend will have to be cut.
A number of big firms have seen their dividend cover fall below one, including Shell, BP and Vodafone. These stocks feature in many equity income funds, so any cut in their dividends would hit many investors.
In addition, the 10 FTSE 100 companies predicted to have the highest yield in 2017 have an average dividend cover of 1.3, research from AJ Bell, the fund shop, found. Only one had cover of more than 1.5.
Investors who rely on a handful of stocks for income are playing a dangerous game
One fund manager who has reshuffled his portfolio to help protect against the risk of dividend cuts is Ed Meier, who recently took over the £167m Old Mutual UK Equity Income fund.
He realised that the 10 companies paying the largest dividends in the fund represented about 60pc-65pc of the fund’s total yield, and this made him nervous. He has now reduced the figure to 50pc and wants to cut it further.
However, by reducing the fund’s reliance on a handful of big names he has had to move into some higher risk, or unloved, stocks. “We have moved into a small basket of investments that are relatively high yield and focused on the consumer discretionary sector,” he said.
He acknowledged that some of these shares appeared cheap, reflecting the market’s concerns about them, but said: “This is why the analysis you do on individual stocks is key, so you have your eyes wide open as to why a whole sector is priced where it is.
“It’s a balancing act. We also have some names that maybe yield closer to the market, but have the ability to grow their payout.”
One example of a stock Mr Meier bought is retailer Dunelm Mill, which he called a “stock market darling that fell from grace”. However, it has a yield of 4pc and a “good balance sheet”.
Does buying multiple funds help?
Another problem is that income funds tend to resemble each another. The 10 largest UK income funds all have a positive “correlation” to each other over five years, meaning that returns are likely to rise and fall together.
“It is easy for investors to think that because they own three, four or five funds they have got a spread of exposure,” said Ryan Hughes of AJ Bell.
“They may own Threadneedle, Artemis and Woodford’s income funds, which are three very good funds, but they have a lot of commonality in their holdings. Investors need to understand the different investment styles, look at the top 10 holdings to see where the concentration of risk lies and start thinking more globally.”
Data from Morningstar, the research firm, found that 15 of the 79 UK equity income funds it analysed received more than 50pc of their yield from their top 10 holdings.
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In recent years the task of diversifying has been made easier as more income funds have launched that invest either across the globe or in medium-sized and smaller UK companies, moving away from the same old names in the FTSE 100.
Mr Hughes recommended the Newton Global Income fund, a “very solid holding to sit alongside more traditional UK income funds”, and Artemis Global Income, which he said invests very differently from the big UK income portfolios.
For investors who want to stay in the UK but spread their risk across more companies, the Montanaro UK Income fund specialises in small and medium-sized UK companies.
“It often means looking away from the familiar names, and it has done a fantastic job over the past 10, 15 and 20 years,” Mr Hughes said.
