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Income funds are buying bad stocks for high yields, warns Baillie Gifford’s Dow

09 November 2022

Many equity income funds entice investors with their high yields but are at serious risk of sharp dividend cuts when the UK enters a recession.

By Tom Aylott,

Reporter, Trustnet

Many equity income managers are buying poor-quality companies with high dividends to boost their fund’s yield, according to James Dow, manager of the Baillie Gifford Responsible Global Equity Income fund.

He said that most funds in the IA Global Equity Income sector hold high dividend payers such as Shell and BP because it makes the portfolio’s overall yield more attractive to investors.

BP and Shell currently have yields of 3.68% and 3.17%, but some equity income managers overlook the fact that these companies face structural problems and the likelihood of dividend cuts, according to Dow.

He said: “Most income funds out there start in the marketing department. They say, ‘to sell this fund we need a 4-5% yield – what can you go out and buy?’

“Then they have to buy BP and Shell and maybe National Grid, so they end up reverse engineering the portfolio.”

Instead, it’s better to buy a company with a lower starting yield of between 2.5% and 3% that has more room for growth over the long term.

For example, although Dow’s holdings in Apple and Microsoft yield a relatively low 0.66% and 1.19% respectively, their ability to increase those dividend payments over time is greater than mature businesses.

“You're going to get way more capital growth and income out of these companies despite the lower starting yield,” Dow said.

This ability to grow yields even through challenging periods will be especially important now, according to Dow, as central banks around the world have turned off the monetary policy taps and are actively raising interest rates to combat inflation – something that could lead to a global recession.

Companies with a low but increasing dividend will be more resilient than those with above average yields, who could struggle to maintain these high pay-outs.

Dow said: “Our companies’ dividends have got to be resilient because, if we have a recession in the next 12 to 18 months, we and our clients need to feel comfortable that these companies will continue delivering dividends even in those tough times.”

The resilience of low-yield payers became apparent in the market downturn of 2020, when nine of the top 10 holdings in the Responsible Global Equity Income fund increased their dividends, while high yielding companies such as Shell and BP were forced to cut their pay-outs.

Richard Saldanha, manager of the Aviva Global Equity Income fund, agreed with Dow, pointing to the Covid pandemic as a good example of how companies reacted under stress.

He is another equity income manager who has not been tempted by high yielding assets, and said that moving forward, these stocks will likely lose the allure they currently have.

“Historically, they've been the bedrock of income funds, but we don't think that should be the case going forward frankly,” he said.

Investors who have exposure to these types of companies within their portfolios may be enjoying a generous dividend income for the time being, but should brace themselves for cuts in future, Saldanha warned.

He said: “If you require an income from your investments, you really want to question why you want to be owning these companies because you can't depend on them for income. Certainly not in downturns and recessionary periods.

“We’d caution investors who want to own these companies because they’re paying a high dividend but ultimately have to cut their dividends in recessions or downturns.”

Alternatively, investors can rely on more steady streams of revenue from low-yielding assets that will be better equipped to maintain their present level of pay-outs.

Saldanha said: “It’s better to go for a company that’s going up from a lower yield than one that is suddenly going to cut its dividend in a recession.”

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