Ultra-low bond yields and high dividend yields suggest low-risk investors should consider equity income funds. Joseph Mariathasan looks at the options
Yields on 10-year Bunds were at 1.5% in mid-January, reflecting the drop in quality bond yields across the globe and across many debt asset classes. As a result, the case for looking at equities for income is getting stronger.
“With current levels of the equity risk premium and current dividend yields, particularly in European equities, the risk of the total return being wiped out by volatility has gone down,” says Stephanie Butcher, manager of Invesco’s European income strategies. “It is becoming more valid for lower-risk clients to start looking at equities.”
There are a number of very different approaches to constructing equity-related income funds. One is writing covered call options. UBP Investment Management recently launched a sustainable-dividend European equity product targeting European large-cap stocks paying attractive dividends and supported by an option overlay which aims to deliver a bond-like income stream.
UBP portfolio manager Rob Jones explains that the strategy owns 22 equally-weighted stocks from a universe of around 50 large-caps with balance sheet strength, dividend cover and a dividend history of no cuts greater than 50% over the past decade. It favours liquid, defensive stocks like Shell, Nestlé and Roche. The average yield on the stocks is 4.5%, but the strategy aims to generate around the same amount by writing call options on each stock every day of every month, so that 100% of the stocks have call options written against them 100% of the time. In 2012, the fund delivered 7.5% in a period when European equities delivered a total return of 18%.
“What changed was not the dividend yield, but the drop in implied equity volatility, which meant premium income from writing call options gathered less income than we hoped,” says Jones.
As volatility goes down, often the case when stock markets move strongly up, the premium income is reduced but the transaction costs of option trading remain the same – and, of course, the downside exposure remains the same, too. In those circumstances the strategy becomes clearly less attractive. Jones argues that for some investors, generating 7.5% is attractive compared with the bond alternative – but it is possible to construct attractive yielding equity portfolios without the use of option writing.
There are sectors of the equity market that have historically been seen as structurally suitable for dividend investing. But, as Will James, portfolio manager at Standard Life Investments argues, there are three income sectors that have been very disappointing over the past five years, even though they are generally good for income stocks: banks have clearly failed to deliver as write-downs, de-leveraging and a host of other problems have seen them cutting dividends; and both telecoms and utilities have also had to cut back on dividends as the expected cash flows arising from their debt-fuelled growth have failed to materialise.
James sees three opportunities for gaining access to attractive dividend streams. First, some stocks – and not necessarily the obvious ones – are still returning a high and sustainable dividend yield of 4.5-6%.
“Austria Post is one with a 6% yield,” he observes. “Mail services may have anaemic top-line growth but what that misses is the strength of the management team at the company that recognises the strengths and the weaknesses of its business model. They turned the business around in 2011 to create a sustainable model.”
The second opportunity is in companies that may have relatively low dividend yields now, but which are set to grow dividends at a higher rate than that of the market – in some instances at over 20% per annum. “Paddy Power is a good example of this,” says James.
“If you had invested in 2009, you would have had a historic dividend yield of 4%, but since then they have more than doubled their dividend and had significant capital appreciation.”
The final, smaller opportunity is in companies that have upgraded their dividends. This is where the market assumed that the existing dividend was not sustainable because revenue projections were being challenged, and a cut was expected.
“Electrolux, the Swedish white goods manufacturer is a case in point,” says James. “In September 2011 analysts and the market felt dividends were unsustainable as demand was going in the wrong direction. But on the basis of the balance sheet and meetings with management, it seemed odd for them to cut the dividend. By early 2012, there was better market sentiment and the company announced that they would sustain their dividend.”
James is underweight utilities and banks, and overweight telecoms, consumer services (including everything from media to companies like Paddy Power) and non-life insurance and reinsurance companies. There is also something of a geographical – or rather jurisdictional – bias. James points out that investors still incur a 15% withholding tax in Germany, despite double taxation treaties.
“This means that a German company, all other things being equal, would have to give a 15% premium in dividend yield to match the cash flow from a comparable Swedish company,” he says. Moreover, while the Nordic regions have sensible dividend policies with both ordinary dividends and excess cash paid out as special dividends, in Germany the approach is different. “Dividend policies are based on payout ratios. If earnings are down, companies cut their dividends, so the volatility of dividend cash streams is higher in Germany than elsewhere. There is not a level playing field in Europe.”
Butcher’s approach is substantially different, focusing on valuations and pragmatic in terms of styles. This translates to much more emphasis on peripheral euro-zone countries and the financial sector. Indeed, she sees the banking sector as the place to look today for big yields.
“Post the crisis and associated regulatory changes, the likelihood is that we will see more conservative banks which will be much more focused on capital and in a position to pay decent yields,” she argues. Reassessing the regulatory and political environment for high dividend stocks may be key to producing stable dividend portfolios.
Europe is an attractive region for constructing equity income funds – but they need to be based on a sound assessment of the future, not on assumptions based on the post-crisis experience of the past five years.