Higher yields and a resurgence in dividends are welcome news for charities with regular spending commitments.
At Sarasin & Partners we have long advocated that natural income – company dividends, property rental income, and interest from bonds – should meet a material proportion of our charity clients’ regular spending requirements.
We believe charities should seek to adopt a total return approach to withdrawals, one that uses the returns generated from both capital and income. Within this, the bulk of the heavy lifting for withdrawals should be done by durable income streams that can at least keep pace with, or exceed, inflation.
Capital returns can be extraordinarily volatile, while income returns have been much more consistent.
It is prudent for the majority of trustees’ spending to be covered by more dependable natural income flows.
By diversifying investments within and across a wide range of asset classes, we have developed a long track record in building investment strategies that have solid, growing income streams at their core.
The income conundrum
In recent years, opportunities for sourcing attractive and resilient income streams have been limited. An environment of ultra-low interest rates and historic lows for both bond and equity yields, together with the introduction of zero-yielding assets such as private equity and hedge fund strategies, has meant that multi-asset portfolios have generated much lower income returns. In fact, the trend income yield of an endowments-style portfolio has been falling continuously since the 1970s, as the following chart illustrates.
Coming at the end of a decade of declining interest rates and bond yields, the COVID-19 pandemic and the slashing of interest rates around the world to emergency levels effectively sounded the death knell for income investors. In the UK, rates were cut to just 0.10% in early March 2020 as the Bank of England scrambled to protect and stimulate the economy. Remarkably, they stayed at this level for nearly two years until 15 December 2021, when the current slew of rate increases began in earnest. By 4 August 2020 the yield on 10-year gilts fell below 0.07% and finished the year at only 0.13%. It was an even starker picture in Europe, where 10-year bond yields fell further into negative territory, reaching an all-time low of -0.84% soon after the first wave of the pandemic struck.
And the dividend nadir
Equity investors fared little better. Janus Henderson, an asset manager, estimates that global dividends fell by 12.2% in 2020, the worst decline since WWII. Cuts were felt most keenly in the UK and, to a lesser extent, Europe, which together accounted for more than half of the total reduction in global pay-outs.
UK dividends fell by an astonishing 40.9%, in large part because of the UK stock market’s skew towards heavy industry, energy and traditional banking, all of which were badly hit by the pandemic-induced economic slowdown. Unless investment managers were able to call on income reserves or supplement receipts with less conventional measures such as option writing, many charity investors had to weather a material cut to their distributions and spending.
What a difference two years can make
Today, the pandemic and its immediate aftermath seem a distant memory. With interest rates back up at levels last seen over 15 years ago, bond yields commensurately higher and dividends having rebounded strongly, we appear to be entering a renaissance for income investing.
The Bank of England base rate has risen by 4.4% in the space of 16 months and, at the time of writing, markets expect it to reach 5.75% by February 2024. Twelve-month fixed term deposits provided by top tier, A-rated institutions have been offered as high as 5.4% in recent weeks.
UK bond markets also look attractive relative to global peers. Financial and political risk has moderated from nine months ago and diminishing fiscal risks have prompted S&P Global Ratings to shift the outlook for the UK from negative to stable. This, combined with a sharp repricing in future interest rate expectations has seen the differential between UK and US government bond yields move in the UK’s favour, a trend that may well entice international investors.
Investors willing to adopt credit risk (by investing in company debt) in addition to interest rate risk are being rewarded equally handsomely: the yield to maturity on high-quality investment grade corporate bonds now sits at approximately 5.5%.
Interest rates may well have further to rise – which could threaten capital values in the short-term – and inflation is proving much sticker than central banks had anticipated. However, yields are now attractive in a range of assets that includes bonds, property and infrastructure. For the first time in a number of years, a case can be made for nominal assets offering a real return over a sensible investment time horizon.
Dividends roar back
The resurgence in dividend pay-outs has been equally vigorous. 2021 saw a sharp rebound in dividends as companies reinstated payments that had been paused or cancelled, and regulators allowed financial institutions to reinstate shareholder distributions.
Last year, global dividends rose by 8.4% to a record $1.56 trillion. In local currency terms, growth was even stronger – closer to 14% – with 88% of companies either maintaining or raising their payments. Emerging markets, Asia Pacific and Europe led the charge with an average dividend growth rate of 20%. Elsewhere, records were set in the US, China and Brazil.
Looking ahead, the picture looks equally optimistic. The growth in dividends seen over the past two years is unlikely to be repeated. Nonetheless, forecasts are for positive dividend growth, with the consensus forecast for one year ahead placing it close to its 20-year average. In current market conditions, where equity gains have been heavily concentrated in a small group of US tech companies, a global equity income approach with a focus on dividend growth offers welcome defensive characteristics.
New markets for income
New markets are opening up to income investors, partly thanks to corporate governance and shareholder engagement. Even in Japan, where shareholder distributions have been notoriously hard to come by, things are changing. There are signs that the late Prime Minister Abe’s famous ‘third arrow’ of structural reforms, which focused on stimulating growth and improving corporate governance, is starting to bear fruit.
For the past two years, the yield on the Nikkei 225 Index has outstripped that of the S&P 500, possibly the result of the huge cash reserves that have accumulated on Japanese company balance sheets. A Tokyo Stock Exchange initiative to impose penalties on companies that fail to take steps to increase their book values is likely to further increase pay-outs to shareholders among the 50% of listed Japanese companies that fall within the initiative’s scope.
Go global for diversification
The resurgence in interest rates, bond yields and dividends is a welcome development for all charity investors, not only those specifically seeking income. Even for those adopting a total return approach, having access to growing income streams has an important role to play. They offer more consistent and less volatile returns than capital, with a powerful compounding effect that can enhance overall returns over time.
When we deconstruct the long-term returns from equity markets in the Sarasin Compendium of Investment, we find that the vast majority of equity market growth is derived from dividends and dividend growth; very little can be attributed to fluctuations in valuations. Taking the US as an example, equities have delivered a long-term return of 10.5% per annum going back to 1928. Of this, over 9.2% is attributable to dividends and dividend growth, with the balance coming from changes in valuation.
As well as adopting a total return approach, we believe charities should consider the benefits of global allocations as opposed to retaining a focus on UK markets. The pandemic provided a salutary lesson in the risks of relying too heavily on a relatively concentrated group of UK dividend payers, or companies that over-distribute to shareholders. Opening up investment opportunities to include global markets not only improves diversification of income sources but also brings the potential for higher dividend growth in nascent markets and growth industries.
 Macrobond, 20.06.2023
 Janus Henderson Global Pandemic caused $200bn of global dividends cuts in 2020, but the decline was less severe than feared, press release, January 2021
 Bloomberg, 13.06.2023, market implied OIS rate
 Bloomberg, 01.06.2023, indicative Santander PLC UK money markets rate
 Refinitiv, 13.06.2023
 Janus Henderson, Global Dividend Index, Edition 31, p2
 Bloomberg, https://www.bloomberg.com/news/articles/2023-02-22/tokyo-bourse-s-buried-notice-spurs-surges-in-cheap-japan-stocks#xj4y7vzkg
 Sarasin & Partners, Compendium of Investment, 2022 edition, p. 4
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