Invesco: Dilemmas for securing income as dividends come under pressure

Income has been thrown firmly in the spotlight this year with dividend cuts happening across the Financials sector and elsewhere, highlighting the importance of diversifying income sources.

Hopefully, this is a temporary suspension of an important component of equity income. Prior to the Global Financial Crisis, banks accounted for over 20% of dividends within the FTSE 100 index. Banks are less important now than they were, but they still accounted for around 15% of overall index dividends last year, while energy companies accounted for around 22% of overall index dividends.

It is also startling to see that 20 stocks within the FTSE 100 index account for 74% of total market dividends (19 stocks if you combine the two Royal Dutch Shell share classes).

Outside of the UK, announcements in Germany and France are also putting dividends under pressure, with Germany urging any company that receives state aid to not pay a dividend. Meanwhile, state-backed companies in France are likely to be asked to stop paying dividends to shareholders.

Dividend futures (yes, they do exist!) have priced in a pretty dramatic cut in dividends already. The FTSE 100 December 2020 dividend future remains 38% below February levels to reflect the expected cuts to dividends this year (and also in part the fall in the equity to adjust the dividend yield to the market level).

The importance of focusing on income equity managers who do not ‘major’ on simply the highest dividend payers but focus on companies that can grow dividends and provide capital growth potential is crucial at times like these. But also having access to a broader range of options to generate income can help diversify the income component of a portfolio.

Given this significant change for equity income I thought it would be helpful to give a breakdown of how we are generating income in the Invesco Global Targeted Income strategy to continue to honour our 3-month LIBOR plus 3.5% p.a. gross income target in these challenging times.

The first important point is that not every position within the strategy has to generate an income. For our capital preservation objective, we need investment ideas that can provide some help in protecting capital and can potentially deliver capital growth in risk off periods for markets. These ideas help to balance the risk we are taking in income generating ideas such as credit and selective equity markets.

For 2019, the income breakdown was as per Figure 2 below. Note that equity dividends were already the smallest component of our overall income generation in 2019 and we have reduced that further in 2020.

As at 30 June 2020, equity dividends were expected to contribute close to zero income to our 3-month LIBOR plus 3.5% income target, which currently equates to roughly 4.1% over one year. Given the flexibility of  our strategy, we can look to replace that with other sources of income if dividends outside of the banks get cut further.

How are we generating income?

Credit is still an important component of income, and at a portfolio level, we prefer credit to equity given the policy measures which in Europe, for example, are supporting investment grade credit markets.

We lost money on our credit positions in the first quarter, but they subsequently recovered in Q2. During Q1, other ideas which are in the portfolio to generate a capital return acted as a defensive offset to our credit and equity positions.

Ideas such as buying the Japanese Yen, buying US bonds versus selling European bonds and buying volatility were all very helpful during the equity and credit market falls earlier in the year. Currency continues to be the most important income generator for the portfolio alongside selective bond positions such as Mexican bonds which have performed well year-to-date as yields have fallen but continue to offer an attractive income for investors versus other asset types.

We are working hard to continue to generate a consistent level of income for our investors, but importantly to do so without taking too much capital risk in what continues to be an incredibly volatile market environment.

Related insights

Invesco: Policymakers rethink
Diversification – too much is just right
 

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.

Invesco Global Targeted Income Strategy - Please refer to the risks numbered  2 and 3

1. Changes in interest rates will result in fluctuations in value.

2. The strategy uses derivatives (complex instruments) for investment purposes, which may result in a portfolio being significantly leveraged and may result in large fluctuations in value. The strategy may hold debt instruments which are of lower credit quality which may result in large fluctuations in value.

3. As a portion of the strategy may be exposed to less developed countries, you should be prepared to accept large fluctuations in value.

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