Generating income has been challenging in recent years and many investors have turned to dividends to maintain yield and income levels. But after ten years of a bull market, income-seeking investors are now facing a new challenge: managing income as the dividend cycle in Australian equities begins to mature.
“A lot of the market really is facing quite a lot of pressure when it comes to dividends,” says Tom Young, Co-Portfolio Manager, Australian Equities at AMP Capital.
The good news is that strong income opportunities still exist, and if investors – particularly retirees – set realistic expectations and shift to sustainable yield, they can navigate the current environment, but also generate smoother income streams across the entire cycle.
Young says that many of the traditional dividend-paying sectors are now struggling. “Profit growth is lacklustre, starting dividends and payout ratios are high, disruption in some sectors is crimping margins and there are building risks that some dividends may be cut.”
Sectors that have cut, or could cut, dividends include telcos, retailers, listed property and banks. Banks, Australia’s largest dividend paying sector, haven’t been able to increase their dividends per share since 2014. Young says that increasing competition means they may continue to struggle to grow dividends meaningfully.
The consensus forecast dividend growth for the overall Australian market in the next couple of years is 4.25% per annum. But Young says that consensus is usually too optimistic, and if you assume banks cut dividends by 5%, market growth falls to less than 3% per annum.
“Those forecasts are telling you the dividend cycle is quite mature and the market is struggling to grow dividends.”
Setting realistic expectations
Young says one of the worst mistakes investors can make is to chase yield at this mature end of the cycle. “There is a lot of evidence to suggest it doesn’t work,” he says. “You end up taking on more risk than you think and can end up overexposed to companies that cut their dividend.”
Investors must now set realistic expectations around returns.
Matthew Hopkins, Senior Portfolio Manager of AMP Capital’s Multi-Asset Group, agrees that generating income is becoming more difficult, with falling yields on fixed income, and now the challenge of maintaining high dividend yields. “It’s normally never the best strategy to aim for just the highest yields,” he says.
“Lower and sustainable [yields] have usually produced the best results and this is what our processes aim for. We have added a new strategy within our Australian Equities specifically aiming for opportunities not normally known as ‘income stocks’.”
The AMP Capital Equity Income Generator Fund (“Fund”) has lowered its yield target, including franking credits, from 7.3% per annum to 6.3% per annum to reflect the later stage of the market cycle.
Young says the target reduction allows the Fund to focus on capital growth and to avoid riskier parts of the market that have high short-term dividends that could be cut. “We think this pre-emptive move will ultimately help us to navigate the next phase of the market.”
The reduction is part of a broader counter-cyclical approach to the Fund’s yield target. Young notes that in the latter stages of a market cycle the fund will have a lower yield, instead electing to focus on income stability. Conversely, in the earlier stages of a market cycle when the dividend growth outlook is stronger the Fund’s yield is expected to be higher. “This counter cyclical approach provides income investors with a more stable dollar income stream through-the-cycle than if the fund targeted the same dividend yield all the time,” he says.
Focused on opportunities
Hopkins says that in addition to setting realistic expectations, in the current environment investors need to be focusing on resilient income. “There are still businesses in Australia that are producing very high-quality earnings,” he says, adding that includes some financial institutions outside banks like major insurers.
Hopkins notes that while some traditional dividend stocks are challenged, other opportunities are available in sectors like aged care which is benefiting from an aging population. “One part of the market shrinks, but other markets are emerging,” he says.
Outside equities, Hopkins also likes community infrastructure which is “playing a great role in offering more diversity and higher yielding income”.
Young says that despite a challenging outlook for parts of the market, “there are actually a lot of opportunities in reasonably defensive parts of the market”.
In the later part of the cycle, investors tend to overvalue growth and undervalue safe and reliable, but somewhat ‘boring’, income streams, Young says. “For retirees safe and boring is often the best form of income,” he notes.
Young agrees that aged care provides a strong opportunity, as do utilities and infrastructure: “They can be lower growth, but they typically have very defensive income streams.”
Additional income hope
Hopkins adds that another source of future opportunity and hope for income investors is rising rates. Official interest rates and bond yields, while still remaining low, have stabilised and in some markets like the US, are now rising. “It is likely the bottom is in for rates,” he says.
“Higher real rates are better than lower ones as long as higher rates reflect strong economic growth, which should be reflected in high earnings and higher dividends - that’s a good thing,” Hopkins adds.
But the path to higher rates is normally volatile and usually causes values to reprice downwards. Hopkins says investors need to therefore build portfolios that are mindful of the impact from higher rates.
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