UK equity-income funds struggle for yield

The immense scale of the credit crisis and the recession that has followed has forced companies to reassess their ability to pay dividends. The near-demise of major banks has wiped out a crucial dividend-paying sector for UK equity income managers—they now face the challenge of finding alternative sources of income for their investors.

Life after the banks
In February 2006, the average fund in the IMA UK Equity Income sector held over 30% in financial services; fast-forward two years and by 31 March 2009 that average exposure had halved to less than 15%. Although it’s risen throughout 2009 to an average of 20% by the end of September—following a sharp rally in the sector since March—it is no longer the rich and reliable source of income that it once was. Royal Bank of Scotland, Halifax Bank of Scotland and Lloyds are not paying a dividend in 2009 and are unlikely to reverse this in the near-term, given their part-ownership by the UK Government. Although independent of government shackles, Barclays and HSBC have also cut their dividends.

This trend is not just limited to the banks; companies such as BT and Xstrata have also cut dividends. Indeed, the number of reliable sources of income has fallen considerably, resulting in a handful of names such as BP and Royal Dutch Shell appearing in the majority of equity income portfolios for the relative safety of their dividends. Both companies declare dividends in US dollars but pay in sterling or euros so, for the 2008 final quarter and 2009 first quarter payments, fund managers received a boost from the dollar strengthening against sterling. But this trend has been reversing since March this year and the fall in price of crude oil could put pressure on their capital expenditure requirements, forcing them also to cut. Indeed, Neil Woodford of Invesco Perpetual has sold his entire stake in both companies on such fears. And let’s not forget the introduction of currency risk too where companies are not paying in sterling. This is yet another reason why managers need to diversify their sources of income.

Some managers look to bonds to add income
As markets collapsed during the last quarter of 2008 and dividend cuts through 2009 looked inevitable, some equity income managers took advantage of dislocated valuations in the corporate bond markets to eke out yield. While we generally prefer them to stick to their skillset, the bond purchases have only been at the edges of portfolios and in the main where firms have fixed income resources they can leverage. For example, Carl Stick of Rathbone Income bought convertible bonds in Mapeley and International Power when he believed the bankruptcy risk implied in the price was overestimated by the market. Furthermore, he knows the companies well through owning the equity and he also leveraged the in-house bond expertise of Bryn Jones.

Co-managers Adrian Gosden and Adrian Frost of Artemis Income have also looked to the realm of fixed income and leveraged their own and their in-house expertise; as of 30 September 2009 they held 5.8% of the portfolio in bonds. Increasing bond exposure, however, was not just limited to Rathbone and Artemis; the average fund in the IMA UK Equity Income sector held 0.3% as at 30 September 2008 but this had risen to 1.4% a year later. We have also seen managers take advantage of their ability to invest 20% of their portfolios in non-UK equities and seek dividends from abroad. Since November 2008, the average exposure to developed Europe has risen from 2.8% to 4.2% as at 30 September 2009. However, investors should be aware that overseas exposure will introduce added currency risk to their portfolios.

Barbell approaches not immune
Another tack has been for managers to focus on providing a strong total return for investors—an approach we think has much merit as the income doesn't matter much if your total returns are poor. A barbell approach—where low-yielding large-cap stocks rub shoulders with higher-yielding small-caps in the portfolio—is an established strategy most often associated with George Luckraft of AXA Framlington Equity Income. However, the current dearth of cheap credit means the likelihood of smaller companies paying a dividend has diminished. The strategy also harbours significant small-cap risk which runs the risk of severe underperformance when small-caps struggle; Luckraft's poor returns demonstrated this well in the second half of 2008.

Ian McLeod-Clarke of BlackRock UK Income also dips down the market-cap ladder, but it’s not a barbell strategy as there is greater concentration in mid-caps and no more than 15% in small-caps, reducing overall small-cap risk. He ensures the fund meets the IMA’s yield criteria by owning FTSE 100 incumbents such as Vodafone and HSBC but looks to add value by investing wherever the best opportunities are, whether it is in the value or growth end of the style spectrum. This pragmatic approach should help to mitigate underperformance if a particular style, such as value, is out of favour at any given time—indeed we believe the fund should be able to perform well in different market conditions, as well as offer the possibility of good total returns, albeit at the cost of some yield.

The road ahead for UK equity income
Despite what may seem like a less-benign environment for equity income managers, it’s not all doom and gloom and there’s an argument to say the path ahead may even be a little easier to tread. The combination of the recent market rally and further dividend cuts has compressed the FTSE All Share Index yield, meaning equity income managers now have a lower target to hit. It does mean investors can expect lower levels of income in the near term but some managers believe the worst of the dividend cuts are behind them and published yields could actually underestimate the actual level of yield next year. The increasing possibility of dividends being reinstated in 2010 could also make it easier for managers to meet the 110% FTSE All Share yield target. And given that the Bank of England base rate is currently at a historical low of 0.5%, the yield of equity income funds is still attractive.

This article was originally written for Professional Adviser.