We are all sadly having to adjust to live with the COVID-19 coronavirus pandemic for longer than we had hoped. Once again, we trust that you and your loved ones remain healthy. Back in early summer we discussed how the virus was impacting income and the outlook for distributions within funds. This autumn update explains developments within the economy and our broad take on income expectations.
- Action to contain the coronavirus has taken a toll but evidence shows that economies have the capacity to rebound quickly thanks to central bank and government support measures, which could see an improvement in income prospects in 2021.
- Yields on bonds appear to have stabilised after months of successive falls; as such the tailwind to rising bond prices is fading but it could lead to an easier environment for reinvesting proceeds from maturing bonds.
- Among equities, economically sensitive sectors have seen reduced payouts and regulatory pressure has curtailed bank dividends; the outlook may improve in 2021 if a more normal economic environment can resume as many companies are more likely to reinstate dividends.
- Rental income from properties is heavily sector dependent, with leisure particularly challenged by lockdown measures, yet industrial warehouses appear to be doing well. Strong relationships with tenants are paramount when seeking to limit vacant properties.
A remarkable recovery
It may be difficult to believe but the global economy has achieved a V-shaped recovery. This is most evident by looking at purchasing manager surveys that enquire whether businesses are seeing an improvement or deterioration in activity – a figure above 50 indicates expansion, anything below 50 indicates contraction. The sharp contraction in Q1-Q2 gave way to more positive news in Q3.
Figure 1: Purchasing Managers’ Index (PMI) surveys
Source: Refinitiv Datastream, Institute for Supply Management (ISM) Non-Manufacturers Survey Index, ISM Purchasing Managers’ Index (Manufacturing), China Caixin PMI Composite, Eurozone Markit PMI Composite, UK Markit/CIPS PMI Composite. Composite includes both manufacturing and services companies, Sep 2019 to Oct 2020.
After a tumultuous loss of economic activity in the second quarter of 2020, the rebound in economic activity in the third quarter was record-breaking. Every major country reported an uplift. In fact, China even managed to grow in both the second and third quarters, admittedly after being more badly affected in the first quarter when the COVID-19 outbreak was at its height in Wuhan province.
Figure 2: Quarterly change in gross domestic product (individual country economic output)
Source: Refinitiv Datastream, percentage change in the level of gross domestic product (GDP) compared with the preceding quarter, adjusted to take into account inflation (real GDP), Q4 2019 to Q3 2020.
Taken together, the global economy looks like it should recover in 2021, as reflected in the latest (October 2020) forecasts from the International Monetary Fund, although there is some change compared with their assessment back in April. Despite the relative strength of China, developing markets appear to be growing less strongly than expected in both 2020 and 2021 as the virus disrupts economies and weighs on demand for commodity exports.
Figure 3: Annual change in gross domestic product (world economic output)
Source: IMF, World Economic Outlook, October 2020. e = estimates. Forecasts are not guaranteed.
The second wave
The main challenge is the second wave of the virus, particularly in the Northern hemisphere where COVID-19 combines with seasonal winter illnesses to increase hospitalisations and deaths. The response of several governments in Europe has been to reintroduce forms of lockdown, albeit typically less stringent than those earlier in the year. This is likely to hamper the pace of the economic recovery, although with workers and supply chains having adapted to this new environment the disruption may be less severe. Nevertheless, the Bank of England, for example, expects growth in the UK to slip back in the final quarter of the year, given that the lockdown coincides with the traditionally busy run-up to Christmas, a critical period for most retail and hospitality-facing businesses. Expectations are that it may be 2022 before most developed economies regain their pre-crisis levels, although the speed at which a proven vaccine could be administered may alter this trajectory. There have already been some hopeful announcements in November but it is clear that the distribution of any vaccine will take time and trials for many vaccines remain ongoing.
Helping to forestall a worse recession has been government and central bank support. Governments have provided financial support to workers through furlough schemes and businesses through grants and loans that should go some way towards bridging the loss in wages and revenues. Central banks have cut interest rates, provided liquidity to markets and created money (quantitative easing) to buy government and corporate bonds to help anchor financing cost at low levels. With interest rates already at or near zero, however, there is a growing consensus that fiscal policy (government spending) may have to do more of the heavy lifting in terms of reviving the economy than monetary (central bank) policy.
How have economic participants responded to this environment?
As we said back in summer, the lockdowns and other safety impositions have restricted economic activity. Many companies have seen a collapse in revenues, household income has been put under strain, and government finances have been hit as tax revenues decline and borrowing rises. Consequently, across the economic system there are strains on the ability of some economic participants to make payments to others.
To preserve cash, many companies have cancelled or deferred dividend payments, some tenants are struggling to meet rent payments to property landlords and weaker companies may be unable to meet their coupon payments on bonds.
What is notable, however, is the resilience of many companies, particularly the larger companies with ready access to the capital markets. They have typically been in a stronger position to borrow, raise equity or sell assets than smaller companies. There has been a clear divergence within markets as companies with already strong finances or operating in sectors less affected by the virus have outperformed. Technology and healthcare have been clear winners while travel and hospitality-related sectors have suffered.
What does this mean for income funds?
As active managers we endeavour to improve outcomes for investors. This means, within our income-orientated funds, we seek out investments where the income is likely to be paid, while being mindful of the capital value of the fund. The abrupt change in the economic outlook in March, however, meant it was not always possible or desirable to reposition away from securities or assets where the income is being deferred or cancelled. For example, companies that cancel a dividend may go on to reinstate the dividend later or in 2021, so the portfolio manager needs to weigh up whether it is worth selling the share or holding it in anticipation of higher total returns (income and capital gain) in the future.
The funds we manage will all perform differently, given the composition of their portfolios. In the main, we are expecting income from equity and property funds to be lower in the fourth quarter of 2020 than would otherwise have been the case due to dividend cancellations and the potential for rental defaults. We would anticipate an improving picture in 2021, even more so if a workable vaccine could be rolled out. The outlook for income from bond funds going into 2021 is that distributions are likely to be similar to 2020 levels, albeit marginally lower given the prevailing lower yield environment.
Before we look at the impact on each asset class, we should be familiar with what is meant by the term yield.
Yield: The level of income on an investment, typically expressed as a percentage. For equities, a common measure is the dividend yield, which divides the dividend payment over the last 12 months by its current share price. For a bond, the simple yield is calculated as the coupon payments over the year divided by the current bond price.
Bonds rank above equities in the capital structure and therefore have an earlier claim on payments that a company makes. This means that while companies have the discretion to cut shareholder dividends, they have an obligation to pay the coupons on their bonds. What is more, where we have seen central bank support measures, these have typically been directed at purchasing bonds, as opposed to other risk assets. For example, the US Federal Reserve, the European Central Bank and the Bank of England all include government and corporate bond purchases within their asset purchase schemes.
Central banks have cut interest rates to record low levels – to zero or negative in some countries. Together with measures to bring down the cost of financing, yields on government bonds in developed economies are near record lows. While the decline in yields represents a valuable capital gain on existing bonds, it means that the ability to reinvest in government bonds at higher yields is curtailed because new bonds that are issued will come with a lower coupon (the annual or semi-annual payment to bondholders). As a result, funds with a high weighting to government bonds are expected to see lower income distributions in the final quarter of 2020 compared with a year earlier. Factors that might cause an uplift in yields would generally be related to an improvement in the economic growth outlook – potential candidates here would be a very large US fiscal stimulus (less likely given a split US Congress) and major improvement on the COVID-19 front (rollout of a mass vaccination programme). Yields do appear to have stabilised in autumn after months of successive falls.
Figure 4: Yields on different types of bonds
Source: Refinitiv Datastream, yields to maturity for: US 10-year Government Index, UK 10-year Government Index, ICE BofA US Corporate Bond Index, ICE BofA Sterling Corporate Bond Index, ICE BofA Global High Yield Bond Index. 31 December 2018 to 31 October 2020. IG = investment grade. Investment grade bonds are deemed to have a higher credit quality and be less risky than sub-investment grade (high yield) bonds. Yields may vary and are not guaranteed.
Yields on corporate bonds initially spiked higher in spring as investors demanded higher yields to lend to companies. This offered a narrow opportunity for some funds to access higher yields but yields have quickly fallen back and the reinvestment risk (the risk that yields will be lower when it comes to reinvesting capital from a maturing bond) has re-emerged. Expectations for income from funds more weighted to corporate bonds are that the income levels are likely to be similar to the levels of the most recent quarters, although outcomes will depend on the composition of the portfolio.
Defaults (the failure of a borrower to meet a repayment to a bondholder) represent a threat to income but defaults are expected to mostly impact sub-investment grade (high yield) bonds. Conversations with our bond portfolio managers suggest that while defaults within bond markets will be higher than recent years, the support programmes put in place by central banks and governments should help to subdue the level of defaults compared with previous crises. Central banks have done an outstanding job in maintaining functioning capital markets – allowing companies to issue record levels of bonds and these bond issues have been met with healthy appetite from investors keen to access the relatively high yields from corporate bonds.
For equity income investors the COVID-19 pandemic has also resulted in dramatic implications for dividend payments. Significantly reduced revenues and profits for many businesses have led to some very hard-hit parts of the market. The impact from COVID-19 on the economy has led to some regions including the UK and Europe experiencing a large number of dividend cuts.
Several large UK companies had been paying out a large portion of their profits as dividends for some time. The pandemic has given many of them an opportunity to reset investor expectations, which should make future payouts more sustainable. Many medium and smaller UK companies, which tend to be more directly exposed to the UK domestic economy, have had to cut their dividends even further. These reductions clearly have implications for the dividend income that will be collected for funds focused on the UK market. Mining company Rio Tinto, however, one of the UK’s top-ten dividend paying companies, announced a slightly increased payout for the third quarter of 2020.
Economically sensitive sectors, such as leisure, airlines and retail, have been most impacted because of the slowdown, along with oil and gas companies with Shell and BP, for example, resetting their dividend payouts at a lower level.
Meanwhile, regulators and central banks in some parts of the world have asked the banking sector to put a hold on paying dividends so that during this challenging period the banks are able to absorb losses on unpaid loans and maintain lending. At the same time, some European insurance companies have paid their dividend. Therefore, the extent of any dividend growth or payments next year will in some cases depend on external factors rather than boardroom decisions.
The very large fiscal (government) and monetary (central bank) stimulus that has been applied to the economy and businesses has helped a lot of companies to stabilise their funding. Company results from the six months after COVID-19 started to impact markets are better than we would have expected. Generally, businesses with financially strong balance sheets have come through this crisis well. We have also seen dividend trends in Asia, the US and Canada being much more stable the longer this crisis has gone on.
The changes to social and working practices because of COVID-19 have benefited many companies and the dividends they pay. We have seen many firms adapt well to home-working environments resulting in an increase in technological innovation across most industries. This has been good for areas like the technology sector, utilities and telecommunications. Many healthcare and pharmaceutical companies have also been resilient and continued to pay dividends.
We expect Japan, Asia and some emerging markets to be less severely affected by dividend cuts or cancellations, but they are also likely to see a more delayed reaction, dragging on growth into 2021. It is notably more difficult to assess the impact of COVID-19 on emerging market dividends than it is on other regions; the contagion has affected some countries, like Brazil, much more than others, whereas in China, dividends for 2020 relate to 2019 profits and are already largely fixed.
This uncertain backdrop highlights the benefits of taking a globally diversified approach to income investing. Large parts of the market are looking attractively valued from a historical perspective. Therefore, we believe that an active approach to equity income enables investment in leading companies that can invest for the future and generate sufficient available cash flow to pay a sustainable dividend that ultimately has the ability to grow over time.
UK commercial property
Returns from UK commercial property are predominantly derived from rental income typically paid on a quarterly basis by the tenant that occupies the property. During the Spring many businesses were forced to shut down as part of the government’s lockdown to try to slow the spread of COVID-19. The current situation is similar with various levels of restrictions in place across the United Kingdom. Again, this is affecting the ability of some businesses to pay rent, notably within the leisure and retail sectors. This will, in time, impact the income distributions that UK commercial property funds can make to investors.
Rents, new lettings and leases
For most asset classes, the portfolio manager has little influence on the performance of the underlying asset. Property is very different. Direct property owners can help shape the returns from the assets they hold. Examples of recent asset management activity on assets owned in the Janus Henderson UK Property PAIF include the completion of a new 25-year lease with a supermarket operator in High Wycombe, a rental uplift secured during a rent review at a leisure unit in Wigan, a lease extension at a logistics unit in Corby and a new lease of 12,000 square feet within an office building in Wimbledon.
Janus Henderson UK Property PAIF rent collection
To help manage the economic effects from the COVID-19 pandemic, our portfolio managers are working with all tenants in the Janus Henderson UK Property PAIF and offered all to move to monthly rents to assist with their cashflow.
Approximately 35% of tenants are currently paying rent monthly and some of these tenants are now subject to rent deferments. A vacant unit at a multi-let industrial premises in Luton continues to be used by the local council for emergency distribution purposes. There is no rent but rate payments are being mitigated for the time being.
As at 30 September 2020, the third quarter (July, August and September) rent collection percentage for the Janus Henderson UK Property PAIF was 83.0%. The alternatives sector (excluding leisure), which includes assets such as a data centre and care homes, and supermarkets had a very strong rent collection rate. Payments from tenants at industrial assets and student housing followed closely at just above 90%. Retail rent collection was just above 70%, while leisure fared the worst with around 40% of rents collected in the third quarter of 2020, although it is worth noting that this sector represents just 7% of total portfolio income.*
Year to date, a value equating to just 2.0% of rents demanded has been written off owing to five tenant defaults, where three of those are COVID-19 related. We have, however, increased our bad debt provision for tenants that have not settled their rent within 90 days or formally accepted a rent deferment. These tenants may pay at a later date but we believe it is best to take a prudent approach in this regard.
Total rent collected year-to-date (30 September 2020) is approximately 80%, which reflects the diversity and strength of the underlying tenant base. While further rental payments are expected, the fund’s distribution levels are likely to be impacted over time by reduced collection rates.*
*Source: Nuveen Real Estate, latest data available as at 9 November 2020.
We believe it is important to support tenants through this challenging time rather than have lots of vacant properties when the crisis is over. Communicating with tenants has also allowed for in-depth conversations on how the investment team can work with occupiers on sustainability matters and energy efficiencies, and potentially taking longer leases as a trade-off for any rental breaks.
The Janus Henderson UK Property PAIF (and its Feeder Fund) remain suspended for dealing to allow for the raising of additional liquidity (cash) to ensure the fund is able to meet both known redemptions on reopening and to have sufficient liquidity to substantially reduce the risk of re-suspension in the short term. Regular updates are being provided via the Janus Henderson website at hgi.co/property-paif.
We do hope that the information within this note helps to give some clarity in terms of income expectations over the short to medium term. Please also refer to the Insights section of our website www.janushenderson.com for further updates from our portfolio managers on COVID-19 and other areas of interest.