The market for income funds is more and more crowded which speaks to both the underlying attraction of the asset class and the willingness of fund houses to play to that demand. The subsequent marketing reinforces the demand, and so on. Thus either the increased demand from funds pushes up the underlying assets or income funds’ style drifts (or discipline breaks down).
Bull / Bear: How to minimise risks in income investing
- Date: 01/09/2017
In theory, investors should be agnostic between income and capital as a source of return, but as we are aware, the taxation environment does skew the outcome and a level of tax arbitration can favour one or other type of return depending on individual circumstances and the prevailing tax regime.
The undeniable fact that a large proportion of the FTSE 100 returns derive from dividend income (AJ Bell calculate it at 74% of the past 30 years’ return) has led to a level of fetishisation of income generation particularly in the UK. This in turn has led British quoted companies to place a value on a dividend stream sometimes to the exclusion of prudence. According to Bloomberg the dividend payout ratio for the FTSE 100 is 97% (97% of earnings are paid out in dividends). In the slightly more diversified UK All Share, the payout ratio is 88.5% while the UK Mid Cap index equivalent figure is 53%.
This tells us two things. First the bulk of dividend income is concentrated in large companies and second that large companies are, in aggregate, sailing close to the wind in order to deliver dividend income. Add in the concentration risk – 5 UK companies provide over 1/3 of the markets total dividends – and it becomes clear that there is some risk in investing into large cap income.
If one is wedded to income, one must therefore diversify income sources. Look to move down the market capitalisation scale where companies might pay a lower yield, but that yield is safer due to lower payout ratios. Lower payout ratios also imply greater flexibility in terms of investing into the business, so ceteris paribus, capital growth rates should be higher over time. As in all things investment related, diversification ends up being your friend.
Finally, I alluded to tax treatment of capital versus income returns above. Clearly this is irrelevant in tax advantaged wrappers such as ISAs and pensions, however in the taxed environment using both sources efficiently can be a huge advantage in terms of tax liability – particularly when the investor is drawing funds. Actively managing that exposure means there is potentially a further £11,000 in tax free capital gains that can be taken to supplement withdrawals funded by dividends.
- Reinvested dividend income is one of the strongest reliable ways to compound returns over time.
Dividend income will continue to play a large part in generating future returns.
- Current dividend yields outstrip corporate bond yields (which is an anomaly historically, albeit has been the norm for much of the period since the financial crisis of 2008). In many cases dividend yields meaningfully exceed the yield on the same company’s debt issuance. While having an eye on debt covenants (dividends have lower precedence than coupon payments) in some cases this implies a negative growth premium in relative terms i.e. you’re paid to be exposed to growth.
- Income payment concentration in the UK market is high – and we saw the consequences of high concentration in portfolios in the financial crisis.
- Dividend cover (the inverse of the payout ratio) particularly at the large cap end of the market has been drifting down as dividend growth outstrips earnings growth. On the face of it, dividends are less secure than in the past. This decrease in cover has coincided with a fall in growth investment, so in the event that companies become more optimistic and begin to invest in future growth, the scope to increase dividends becomes less.
Andrew Herberts ASIP
Head of Private Client Investment Management (UK)
Article first appeared in:
Investment Week (on the 30th August 2017)
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Thomas Miller Investment is the trading name of the businesses in the Thomas Miller Investment Group. This note has been issued by Thomas Miller Wealth Management Limited which is authorised and regulated by the Financial Conduct Authority (Financial Services Register Number 594155) and is a company registered in England, number 08284862