25 Jun 2020
As the extraordinary measures introduced by central banks in the wake of the Global Financial Crisis have created downward structural pressure on traditional sources of income, the challenges facing income investors have steadily grown over the past decade. At the same time, historically low annuity rates, as well as changes to lifestyles and the legal and regulatory environment, particularly the introduction of the Pension Freedoms in 2015, have meant that there is an ever-growing need for assets that produce sustainable and attractive levels of income over the long term. The Covid-19 pandemic and subsequent global economic shutdown has presented additional concerns for these investors.
The Bank of England base rate was as high as 5.75% in July 2007 before tumbling during the Global Financial Crisis to finally rest at what was then an all-time low of 0.50% in March 2009. It was not until August 2018 that the rate crept above this level, albeit marginally at 0.75%. In the meeting on March 10th this year, the Monetary Policy Committee responded to the outbreak of Covid-19 by reducing the rate to 0.25%, before calling an exceptional meeting just days later to reduce the base rate to 0.10%, the lowest ever.
Historically, low base rates in most developed nations, as well as aggressive asset purchasing programs under Quantitative Easing (QE), have created a number of peculiar consequences. For example, in 2019 a Danish bank launched a mortgage with a negative interest rate of -0.50%. By the end of the mortgage term, the borrower will have paid back less than they borrowed in the first place and kept the capital growth in the meantime.
Below we examine the core investment asset classes and consider what impact the pandemic may have on their ability to generate income in the coming months:
A key determinant for returns on cash is the base rate and as described above, this is currently very low. The interest available on cash deposits has been at or close to zero for many years and short-term money market funds are often unable to generate enough interest to cover the fees incurred in running them. It is unlikely that the interest available on cash will increase materially in the short to medium term and investors will have to seek out returns in other asset classes if they hope to at least maintain pace with inflation over a longer term investment horizon. In the current environment, cash primarily serves as a mechanism for controlling overall risk in a portfolio or as a temporary store of value, rather than as a means for generating returns.
Low base rates and QE have forced yields on government debt ever lower. In countries like Germany, Japan, and Switzerland, the yield has been 0% or even negative in recent years, meaning that the investor is effectively paying the respective government for the privilege of lending them money. The Covid-19 pandemic has exacerbated this trend, with yields on high quality government debt falling, a so-called ‘flight to safety’. In times of crisis, the market typically favours assets that are perceived to be low or no risk, such as debt issued by the strongest developed nations. In the UK, the yield to maturity on a 10- year gilt is currently only around 0.20%, having briefly dipped into negative territory during the heart of the pandemic, significantly lower than the Bank of England target for inflation of 2%.
However, this has led to a bifurcation in markets where the yield on corporate debt has increased. This implies that there is an expectation by the market that the default rate, the percentage of companies unable to service their debt, will also increase. Despite the potentially heightened risk, this may offer an opportunity for adding good quality high yielding income opportunities to a portfolio to counterbalance the reduction in income elsewhere.
Some property portfolios went into 2020 with several lingering issues. In particular, the rise in internet shopping has overshadowed the market for retail units and the lockdown has had a significant impact on the cash flow of many businesses. It is likely that there will be many retailers cutting back on the number of stores in a bid to cut costs and survive the crisis. The EU referendum result caused significant redemptions from the major open-ended investment funds in the UK leading them to shut, and the Covid-19 pandemic has produced a similar result with most funds having a sizable proportion of their portfolio subject to material uncertainty in the underlying valuations.
The UK’s largest operator of shopping centres, Intu, has warned that sites may need to be shut due to mounting financial difficulties. In the first quarter of 2020, rent collection was down by 60% as the company entered into more flexible arrangements with retailers, less than three years after an attempted takeover when the share price was over fifty times higher than it is currently. Whilst not affected as heavily, valuations and yields on office spaces may also come under pressure as companies re-evaluate their needs following a prolonged period of home working for the majority of staff.
As with fixed interest markets, there was a clear disparity in the fortunes of more economically sensitive cyclical companies and those perceived to be more stable. As the crisis developed, several companies were quick to announce a reduction in, or suspension of, their dividends in order to retain cash and be responsive to the needs of their business. Royal Dutch Shell cut its dividend for the first time since World War II and City of London and Troy Income & Growth investment trusts also indicated that future dividends may be cut, although in the short term they have maintained their track records as ‘dividend champions’ by using reserves when required.
In the Janus Henderson Global Investors’ Global Dividend Index Report, it was noted that in a worst-case scenario as much as 35% of dividends could be delayed or cancelled entirely in 2020. Whilst this may seem excessive, the reality is that in many cases this may simply be a condition of the support packages offered to businesses from governments and central banks in exchange for loans or grants, such as the UK’s furlough scheme. Although some firms will have cut their dividends through necessity, it is likely that by the end of this year, a large proportion of dividend payers will have begun to issue again as things stand.
Richard O'Sullivan, Investment Research Manager, RSMR
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This information is for UK Professional Advisers only and should not be given to retail clients.The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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