Investors’ search for income is getting harder by the day. Sector by sector, companies have suspended their dividends under pressure from regulators and politicians. European banks and insurers received their punishment in deep falls in their share prices. Some payouts are also likely to evaporate in the U.S., where any company taking government loans will not be able to issue dividends or buy back shares for up to 12 months once the debt is repaid.
The loss of equity income compounds the pain for investors in a world where interest rates have been slashed to zero and many central banks are effectively capping long-dated bond yields through asset-buying programs. This has intensified demand for companies with strong balance sheets that can continue paying dividends. But now, many reliable income stocks have been put on hiatus.
There is, however, another area in which investors can find income with a degree of security: high-quality corporate bonds. The ranks of highly rated companies in Europe, Britain and the U.S. have important backers in the form of central banks that are buying their debt.
Investors have long followed the mantra of not fighting central banks, so those in search of income are taking the interventions as a signal to buy high-grade credit.
Is now the time to switch out of stocks? Some strategists think that the outpouring of fiscal and monetary support in recent weeks means equities have pretty much fallen to their COVID-19 lows and now provide an attractive entry point for long-term investors.
But two further signals are required before there are grounds for a sustainable recovery in the stock market. The first is conclusive evidence that governments are beating the coronavirus pandemic, with no second-wave outbreaks. The other is valuation, when equity valuations have fallen enough to reflect the imminent recession.
At this juncture, equity market declines in the region of one-third are not seen by analysts as fully reflecting a significant downturn in earnings, while the further suspension of dividends and buybacks should weigh on fragile market sentiment.
How bad could the hit to income be? Equity strategists at Citi estimate that earnings per share and dividends for European companies could halve this year, and that income hunters should focus on segments such as utilities, telecoms and health care.
As for U.S. stocks, the bank expects earnings per share for S&P 500 companies to fall by a quarter, with dividends sliding by 30 per cent. Citi analysts see payouts from consumer staples and utilities as more resilient. Tech is another option, though the earnings-to-dividend payout ratio remains low.
After the financial crisis, three years passed before U.S. payouts were restored fully. This time around, S&P 500 dividend futures indicate it may well take until the end of the decade. That estimate may be exaggerated in the present gloom, but some still predict a lengthy period of meagre growth in dividends.
“We expect the next few years to see dramatic cuts in cash returned to shareholders via dividend payouts,” says John Velis, macro strategist at BNY Mellon.
Given the uncertainty over the scale and duration of the imminent economic slump, selective areas of high-grade credit have been attracting buyers. Credit investors have quickly jumped back into the market after a bout of indiscriminate selling hit top-tier corporate debt and created buying opportunities.
Supply is there, too. Companies are building their cash reserves, with U.S. investment-grade debt sales hitting a record US$261-billion in March, according to Bank of America. Expect that to continue this month, as investors are attracted by the additional yield over government bonds. Fund managers are also mindful that higher-quality companies stand to survive this economic tempest, with some groups emerging stronger as more indebted rivals wither.
Another important consideration for income-seekers is the trajectory of the ultimate economic recovery. The past decade has shown the value of owning a combination of high income-paying and fast-growing companies against a backdrop of poor demographics, high debt and low inflation.
Some argue that government spending and unlimited debt purchases by central banks will push inflation higher. If that were to happen, owning fixed-rate debt would be painful. That said, such an outcome will take time to arrive given the shutdown of economic activity and the collapse in commodity prices. Buyers of high-grade corporate debt with a maturity inside four years could well have time to shift their portfolios toward equities as dividends return.
Income might keep its lustre for longer, should the great wave of fiscal stimulus fall short of repairing the damage inflicted by coronavirus. That’s a thesis of the latest working paper from the Federal Reserve Bank of San Francisco on the “Longer-Run Economic Consequences of Pandemics.”
Its authors argue that “investment demand is likely to wane, as labour scarcity in the economy suppresses the need for high investment.”
That suggests a bigger glut in savings to come, weighing on the eventual recovery in global economies and giving further urgency to the hunt for income.
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