Dividends – the darling of income investors, are now in lockdown. The biggest demand shock in living memory has sent a vital cog of the income machine into crisis as corporates rush to shore up capital. But rather than reverting back to dividend payouts to replenish the income drought at the end of this crisis, a re-think around their appropriateness is long overdue and likely to weigh heavily on their future size and predictability.
A shift in mindset
Investors are becoming increasingly conscious of how they allocate their capital, therefore the subsequent rise in ESG and sustainable investing is pressuring companies to re-assess how they manage and invest for outcomes beyond that of just the financial. Additionally, with ESG-integrated funds having outperformed during this crisis period, the voice of sustainable investors is becoming progressively louder. Decision making by corporate executives and board members will come under greater scrutiny as they become increasingly tasked with responsibility for the long-term benefits of all stakeholders. Therefore, the justification of any allocation of capital such as a dividend or share buyback in lieu of growth capital expenditure, or other uses that could be more long-term, value-add in nature, will come under the spotlight. Indeed, given half the FTSE 100 dividends were coming from just three sectors that are already wrestling with significant ESG related issues – Banks, Miners and Energy – this trend may become even more pronounced.
Predictability is key
Post-coronavirus Stakeholders will likely demand higher liquidity buffers, less operational leverage and more stable cash flows. This translates to less growth upside available to pay out as dividends and share buybacks, but will however be music to the ears of creditors. Companies or sectors with formal bailouts or large equity ownerships from governments are also likely to be prohibited from equity distributions, just as the banks were post the Financial Crisis.
And while governments may exacerbate the challenges of equity distributions, they are actively ensuring that bond holders, even high-yield rated bond holders, are paid. The Federal Reserve’s Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF) will provide stopgaps where necessary to ensure contractual liabilities and obligations, such as coupons and principal repayments, are met – but dividends, being discretionary, are well out of scope. Indeed, this is even more explicit in the case of eurozone banks which have been ordered to freeze dividends and share buybacks by the European Central Bank.
The coming of age of high yield
A likely beneficiary of the loss of a dependable, liquid, high-income generation from equity is another asset class boasting exactly those attributes, albeit one that still conjures more risk in investors’ minds than today’s reality merits. Finally, the time has come to detach from its former reputation, as yield-hungry investors are now more willing to listen, and because the asset class itself now stands up to scrutiny in ways it couldn’t a decade ago.
High yield is now of a higher credit rating than ever before – and we can thank the rating agencies for it. Their immediate crisis reaction to wholesale downgrade anything with a tinge of cyclicality has turbocharged the trend of improved credit quality – the asset class is now rated BB- in aggregate for the first time in its history, and the proportion of its debt rated CCC, the lowest band, is just 8% – half what it was a decade ago.
This explosion of ‘fallen angels’ has left many of the world’s leaders in cyclical sectors – Automotive, Mining, Chemicals, Metals – as high-yield credits. ‘High yield’ maybe; but are they ‘Junk’? Indeed, the asset class is no longer dominated by leveraged buyouts, the vast majority of high yield companies today have public market capitalisation, and therefore name-recognition. Do investors think of household names such as Ford, Levi’s, or Kraft Heinz as junk, or as mature, likely dividend-paying businesses?
High yield also boasts significant diversification benefits – it now a genuinely global asset class with companies representing 85 countries – a long way from the US-dominated ground of years before. The securities issued are widely spread across every sector, with varying seniority, currencies and maturities. Compare that to FTSE 100 dividends where 10 firms pay two thirds of the entire dividend, and two of those top five are BP and Shell. With oil having recently slumped to historic lows, causing increasing doubt on those future distributions, the benefits of a diversified income stream is more attractive than ever before. Whilst not mirroring the liquidity of the equity markets, high yield is now a $2 trillion asset class that is widely accessible. The average issue size is now $700m – some 40% larger than 2010 and there are over 1,500 of them to choose from, allowing active managers to thrive and avoid the inevitable pitfalls that come with investing in speculative grade debt.
Just in the nick of time for income investors, high yield is now a credible alternative to dividend equity, redefining what could become the new cornerstone of a sustainable income strategy.
