By Simon Wood, Head of Manager Research, Investment Solutions
Generating income has always been important for investors, but in recent years it has become increasingly hard to achieve. In the aftermath of the post-EU referendum turmoil, the yield on 10-year UK government bonds plunged below 1%. Even before that, it had become more and more difficult to find investments that paid out a reasonable level of income.
Faced with bond yields close to - or even less than - zero, investors have increasingly looked to equity markets as a source of income. But the global financial crisis was not kind to equity income investors. In the UK, we lost almost a third of the total value of dividends, as the recession bit. Financial companies, which had previously been generous dividend providers, were forced into particularly savage dividend cuts.
Dividends under pressure
In recent months, FTSE-listed miners, which have traditionally been among the main suppliers of income to UK investors, have slashed or suspended dividends as revenues dwindled following the collapse in commodity prices. Investors in Rio Tinto, Glencore, Anglo American and BHP Billiton have all suffered dividend cuts.
Companies across most sectors have been affected to a greater or lesser extent. In February, Rolls-Royce - previously a mainstay for most income portfolios - cut its dividend by 50% after warning a slowdown in profits growth.
Income funds struggle to hit yield requirements
As a result, many income funds are now finding it difficult to meet the Investment Association's (IA) requirements for membership of the income sector. The IA stipulates that to qualify an 'income' fund must yield more than 110% of the FTSE All-Share yield over a rolling three-year period.
In the last few years, some of the most popular income funds have failed to meet this standard and have lost the right to be classified in this sector. This includes funds run by Jupiter, Invesco and Schroders.
The managers of income funds are understandably keen to hold on to the classification, but in doing so they might not be acting in the best interests of investors. By focusing on companies that pay a sufficiently high historic yield, a fund manager might exclude some very good companies that pay below the required level at the moment, but are well positioned to grow dividends in the future. Instead, they run the risk of holding companies that are stretching themselves and are at the most risk of cutting dividends.
Furthermore, pressure on companies to meet the requirements of income fund managers could lead management teams to focus on paying dividends instead of investing in the company for future growth. Any sacrifice in capital expenditure in favour of instant dividend gratification could be detrimental to all investors in the long term, whether they are hoping to achieve capital growth or income.
Dividend cover stretched
There are already signs that levels of dividend cover - which measures the sustainability of a company's dividend payments - are falling. Figures released by The Share Centre and Capital Asset Services towards the end of 2015 showed that the level of dividend cover among FTSE 350 companies had fallen to a six-year low.
Although a track record of long-term dividend growth is a highly attractive attribute in a company, it should not be pursued unquestioningly
Although a track record of long-term dividend growth is a highly attractive attribute in a company, it should not be pursued unquestioningly, especially if it is going to jeapordise the strength of the company's balance sheet.
This is why we welcome the IA's recent decision to review the classification for the income sector. Options currently include reducing the required yield figure to 100% of the FTSE All-Share yield, or removing any formal yield requirement altogether, replacing it with a specific disclosure relating to the fund's income delivery.
There are some very good funds run by highly skilled managers that have the potential to deliver strong returns, but have fallen foul of the IA's current 110% yield requirement. Their funds are potentially being ignored by retail investors who seek income.
This wouldn't prevent us from investing in a particular fund, as we are not constrained by IA classifications. For us it is quality of management that counts. However, we welcome any moves that help provide clarity and potentially improve returns for investors.