What happens when dividends dry up?
How will dividend cuts affect income portfolios?
It’s not an easy time to read financial newspapers if you’re an income investor. Every other headline seems to be another company announcing they will cut or suspend dividends this year as they navigate the Covid-19 crisis. And this includes some of the biggest and most reliable dividend-paying companies: BT has suspended its dividend payout 1 for the first time since it was privatised in 1984, while Shell said it would cut dividends by 66%,2 the first such move by the company in 75 years2. In total, after hitting a record high of more than £100bn in 20193, UK dividend payouts could be cut in half in 20204. This is more than likely to put significant pressure on the dividend yields of income portfolios, which have tilted towards equity holdings over the last decade in the context of historically low bond yields.
Why are dividend yields falling so sharply?
There are three main reasons, all unsurprisingly linked to the Covid-19 pandemic.
- In many cases, companies are dealing with a huge hit to revenues as a result of strict lockdown measures and are simply not in a position to distribute payments to shareholders.
- Some other businesses with more solid fundamentals are still cutting payouts as a prudent measure to boost cash reserves during uncertain times.
- Other companies that are benefitting from government support are either under regulatory pressure to suspend dividends – as in the case for banks in some countries – or have decided it would be inappropriate to maintain them during the crisis.
Whatever the circumstance, the reality for most investors is likely to be a drop in natural income from dividend stocks compared to previous years. Of course, there are some companies that are bucking the trend – Vodafone is the latest high-profile case to announce5 it will maintain its dividend – but seeking these out to sustain equity income in the current climate would likely mean concentrating asset holdings in just a few companies or sectors, increasing risks. There may be some opportunities for investors typically focused on UK dividend stocks to seek yield in other markets and diversify income streams, though the short-term economic headwinds are broadly similar across much of the world.
Looking ahead, the primary focus will be on how the gradual lifting of lockdown measures in developed markets plays out over the coming months, both in terms of the spread of coronavirus and the reactivation of the economy. In an ideal scenario for income investors, those companies with robust fundamentals that have cut dividends as a precaution should be in a strong position to restore payments quickly as economic conditions improve. However, a return to pre-coronavirus normality isn’t likely until a vaccine can be developed and commercialised at a global scale. Realistically, this is probably unlikely to happen for at least another 12-18 months, so income investors should be prepared for dividend payments to remain below the record levels of 2019 for some time.
Amid the uncertainty, there are other implications that income investors should consider as they look ahead to the post-coronavirus era. One is that this unprecedented downturn will likely leave many companies saddled with debt, limiting the scope for dividend payments over the medium term. Another legacy could be the adoption of a more conservative business model, with companies putting more emphasis on maintain healthy cash flows to guard against future shocks. Ultimately, income investors may need to adjust their expectations for natural income over the coming years, maintaining a broad and diversified portfolio and focusing on robust long-term fundamentals.
If you would like to discuss your financial situation, please speak to your financial adviser in the first instance.
Past performance is not indicative of future results.