May 18, 2020

Monday Morning Memo: How The Coronavirus Crisis Hit Income-Oriented Investors

by Detlef Glow.

The quantitative easing of central banks in the aftermath of the financial crisis (2008) and the so-called Euro crisis (2011) led to record low interest rates for corporate and government bonds all around the globe. The resulting low-income environment led investors to buy dividend stocks, as dividends (and therefore also dividend strategies/income funds) were marketed as the new source of stable income, especially as some corporates payed higher dividends on their stocks than interest for their bonds.

This has changed since the COVID-19 pandemic led to a global shutdown that hit the revenue streams of listed companies, as well as the economies massively. The decrease in revenues and the unclear outlook for the future resulted in cut backs on dividends, as corporates aim to use their cash to survive the crisis. Since this is understandable from a corporate point of view, these decisions have a massive impact on investors since they are losing another source of regular income to fulfill their duties or pay their bills. In addition to the actions on the corporate side, the central banks around the world flooded the markets with new money to help the economies to cope with the effects from the shutdown. The restart of quantitative easing programs led to a new dip in interest rates that will prolong the low interest rate environment with all it’s negative effects for income-oriented investors.

As markets started to fall due to the lower revenue expectations, the announced dividend cuts were another disappointment for investors since cash dividend payments are seen as a kind of cushioning in rough markets. As a result, investors in dividend strategies or income funds might have sold their shares, which may have fueled the downturn of the markets further.

That said, I would assume that the current environment with regards to dividend policies will hit the returns of passive strategies harder than actively managed funds because passive funds have to wait until their next scheduled review to adapt to the new environment. Meanwhile, actively managed funds can react immediately to the changes and may be able to buy shares of those companies which are able to maintain a dividend payment even during this crisis.

But it is not only dividends that have been hit by the crisis. As a result of the unpredictable future with regard to global economic growth and the resulting revenues of companies, we may witness a revaluation on the corporate bond market. This is because a number of issuers may face a downgrade of their rating, which will in turn lead to a widening of the credit spread and a loss for existing bond holders, as the price for the bond will be adjusted to the new spread. This may lead to a meltdown of assets in income funds which are heavily invested in high yield corporate debt, as this was, in addition to dividends, another main sources for income over the past few years.

But it is not only funds that have been hit by this. From my point of view, this is also a major risk for the ability of both public and private pension entities to continue contributions to pensions, as also these kind of saving schemes use dividends and high yield bonds to overcome some of the struggles in a low interest rate environment. This is despite missing dividend payments likely being only be a short-term income issue since it is expected that companies will start to pay dividends as soon as they can. However, it is unsure if the dividend payments will reach the levels they had prior to the coronavirus crisis.

The impact from a possible decrease in assets in conjunction with falling interest rates and the subsequent prolonged low interest rate environment will impact pension funds in two ways over the short, as well as the long, term. While the short term is mainly affected by the low income from the decreased interest rates, the pressure on interest rates will exacerbate an already challenging environment for valuing pension liabilities and drive funded ratios further down over the long term.

To sum this up, I would assume that the major impact of the cuts in dividends will affect investors in dividend strategies or income funds only in the short-term, even as they should lower their mid-term expectations for dividend yield since it will take some time for the corporates to reach revenues on the pre-crisis level. Public and private pension entities should also be able to keep their payments stable in the short term since they may have reserve funds for a year such as this. That said, I assume that participants in income funds and pension schemes should prepare themselves for lower than expected pension payments over the long run.

The views expressed are the views of the author, not necessary those of Refintiv.

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