Income to last the distance

ISAs are a good way to shelter investment income, but it has been thin on the ground in 2020. We look at why investors need to look further afield in 2021 to build an income stream that could last the distance.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

No income investor will need reminding that 2020 was a tough year, characterised by sliding bond yields and dividend cuts. Although there are signs of improvement for the year ahead, the experiences of the last 12 months demonstrate that investors need to cast their net widely when building a resilient income stream.

The past year has seen some of the most reliable dividend markets struggle. The UK, for example, where many investors will have a significant weight, was hit hardest by dividend cuts. Between the second and fourth quarter, two thirds of UK companies cut or cancelled their dividends1. Europe, another previously reliable dividend market, was also hard hit.

At the same time, many of the companies that were forced to cut might previously have been considered ‘defensive’ companies. They were the oil majors, banks and mining companies. While sectors such as healthcare, basic consumer goods, food producers and food retail were more resilient, it will have shaken investors’ faith in dependable blue chips.

Investors need to ensure that they are not simply looking for companies that can pay high dividends today, but companies that can grow and pay dividends far into the future.


Macroeconomic risks

The virtues of diversification have been well-flagged, but in 2020, investors saw why it was so important. If investors were geared to the wrong sectors, they may have seen significant losses and may not have participated in the market recovery. Equally, some countries fared notably better than others, showing the benefits of geographic diversification.

As we emerge from the pandemic, it is likely to be into an altered reality. The way we live, work, travel and socialise are all likely to change as we learn to live with COVID-19. It is difficult to imagine that workers will go back to packed commuter trains, or that we will discard our nascent love affair with ecommerce.

With this in mind, there is a real risk for dividend investors in simply relying on those companies that have served them well in the past. As a result of the pandemic, structural decline for many legacy industries is likely to accelerate. Investors need to ensure that they are not simply looking for companies that can pay high dividends today, but companies that can grow and pay dividends far into the future.

Beyond megacaps

To our mind, in order to ensure an income portfolio is properly diversified and is positioned for longer term growth in income and capital, investors need to look beyond these megacaps that often form the core of an equity income portfolio. This is what we aim to do in the BlackRock range of investment trusts.

We believe it is more important than ever that investors should look globally and across a range of sectors. Areas such as frontier markets, smaller companies or commodities could bring in new and differentiated sources of income. This is important in managing risk and building a diversified portfolio.

Growth in dividends is extremely important to help investors beat inflation over time. Inflation may rise as economic recovery takes hold and could exert a drag on portfolios. Dividend growth is far more powerful than simply choosing a high starting dividend with little or no growth and can be particularly useful for those trying to build an income in retirement. To identify those companies likely to see dividend growth, an analysis of cash flow and earning resilience is important.

We believe investment trusts have proved their mettle in 2020. Dividend reserves have cushioned the blow of dividend cuts for investors. We believe the ability to reserve any income received from dividends and interest in buoyant years to pay out in leaner years will continue to be important. This helps deliver consistency of income to shareholders. We use this flexibility across all our trusts with the aim of helping our investors build a stable, diversified income stream over the long term.

1Link Group, January 2021