Equity income fund managers have given a mixed response to the inability of certain banks to pay dividends to shareholders.
Last week Fund Strategy reported that several British banks were considering participating in the government’s recapitalisation scheme. Since then Abbey, HSBC and Standard Chartered have decided to remain apart from the scheme because they are able to recapitalise to the international tier one target from their own resources.
However, last week it was announced that HBOS, Lloyds TSB and Royal Bank of Scotland (RBS) would participate. Under the bail-out terms these three banks will not be allowed to pay dividends to shareholders, until they repay in full the preference shares held by the government. With banks traditionally a yield-rich sector, this rule has caused concern among some equity income managers.
Bill Mott, the manager of the PSigma Income fund, says that while banks are cheap, if they pay no dividends they could be “dead money” for a while, which might make it difficult for income funds to have large weightings in banks and deliver their income requirement.
Mott (pictured) says: “At the moment we are assessing the position and, unless there is a significant deterioration of dividend flows in the rest of the market, we are comfortable that we should be able to increase the dividend this year on the fund, although we will need to monitor the dividend capture closely.”
Toby Thompson, the manager of the New Star Equity Income fund, is also “monitoring the situation”. “The lack of clarity regarding future dividend payments from those UK banks affected by the government rescue plan means that the potential impact on income funds is currently unclear,” he says.
However, Ian Lance, the manager of the Schroder Equity Income fund, has a clearer idea of how his fund will be affected. He says he does not plan to dump banks at any price given their lack of control over their dividend policy. “There is no IMA [Investment Management Association] rule on equity income funds not holding stocks that don’t pay dividends,” says Lance. “Some funds, however, have self-imposed restraints, with the target being to yield more than 110% of the FTSE All-Share.”
Despite this requirement there are several income funds that yield less than the market. So if funds do sell banks owing to dividend concerns, why were many buying mining shares, which yield less than 1%?Lance says his fund has been underweight in banks for several years, with HSBC the only bank in the portfolio. However, he has recently bought into the weakness of the sector.
“The announcement of some banks not paying dividends has not changed this view,” he says.
While only three banks have signed up for government capital, Jeremy Lang, the manager of the Liontrust First Income fund, says all British banks are likely to suspend dividends as a result of the government bail-out.
“The government, quite rightly, is demanding all taxpayers’ money be repaid before dividends can be paid to shareholders,” says Lang (pictured right). “Even Barclays, which says it doesn’t need government help, will stop paying dividends to conserve cash.”
In terms of the fund, Lang says he will remain invested in HSBC because it is the only bank which will continue to pay dividends in the short-term. However, he adds: “Alliance & Leicester has been taken over by Santander so the bank will be sold by the fund.
“Around 6% of the fund is invested in Lloyds and HBOS. I had already discounted a dividend payment from HBOS this year so the only real hole in the fund in terms of dividend payments is Lloyds, which comprises less than 4% of the portfolio.”
The news on bank dividends is another blow for managers of equity income. Increasing pressure on corporate profitability and the need to preserve cash has already resulted in companies outside the banking sector starting to either cut dividends or omit to pay them altogether.
Lang says the difficult economic environment Britain faces over the next year means many non-banks will find it more challenging to sustain dividend payments. “This makes it highly likely that dividends, in aggregate, will fall sharply next year,” he says.
So far this year 50 British companies have either cut or omitted to pay a dividend. This compares with 2007 when no FTSE 100-listed company cut its dividend. If several banks also stop paying out, the asset pool for equity income managers will shrink even further.
While this worries some, Lance says there are plenty of other areas in the market to get income without needing a high banks exposure. For example, he says Vodafone yields about 8%.
“Some banks previously had high yields but we now know these dividends were based on unsustainable earnings,” he says. “The high yield was not indicative of a cheap business, but by the same measure, a short-term lack of yield does not mean they are not good value now.”
Lang is also upbeat that he can maintain the dividend on Liontrust First Income, which has achieved 12 years of rising dividend payments.
“I have achieved this by balancing stocks on high dividend yields and no dividend growth, with safer stocks on lower yields and good growth,” he says. “By getting the balance right I have been able to bear the risk of stocks cutting dividends.”
Julian Cane, the manager of the F&C Equity Income fund, adds that while the three banks may stop paying cash dividends for a period, there may still be “wiggle room” for fund managers. He says that at present auditors are allowing equity income funds to take scrip dividends as income. Scrip dividends give shareholders extra shares, not cash.
The further good news for managers is that the trailing dividend yield on the FTSE All-Share now exceeds the yield on long-dated gilts. The last time this happened was in 2003.