Bond yields are now at their highest level in a decade, pushed up by rising interest rates. What does this mean for the relative merits of dividend-paying equities? David Goldman, manager on the BlackRock Income & Growth Investment Trust (LON:BRIG), looks at why they may still have appeal.
For more information on the BlackRock Income and Growth Investment Trust, please visit: www.blackrock.com/uk/brig
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.
There was a significant change in the income landscape in 2022. Higher interest rates meant that for the first time in a decade, bonds now pay an income comparable to that available from company dividends. This creates a greater hurdle for equity income investors, but we still see real value in choosing stock markets for income.
Inflation has been the big story of 2022. For much of the year, inflation surprised financial markets with its depth and breadth, outpacing the expectations of central banks. It has been fuelled by rising commodities prices, resilient demand, supply chain constraints and, increasingly, rising wages.
For those investors who rely on the income they receive from their investments, this presents a dilemma. Their income may be the same, but it is less valuable. While it is easy to dismiss this as a temporary phenomenon, it seems increasingly clear that inflation may settle at a higher level. The BlackRock Investment Institute says: “We expect inflation to cool but stay persistently higher than central bank targets of 2%…We see long-term drivers of the new regime such as aging workforces keeping inflation above pre-pandemic levels.”
Inflation protection
Holding dividend-paying equities can help protect an investor’s income against the damage caused by inflation. With bonds, the income is usually fixed. It will stay static over the lifespan of the bond. This means bonds are likely to become less valuable at a time of rising inflation.
Fixed income risk:Two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to repay the principal and make interest payments.
In contrast, companies may be able to pass on cost increases to their customers during periods of rising prices. This can help dividends keep pace with inflation. In the fourth quarter of 2022, UK dividends rose 8% to £94.3bn on a headline basis, according to the Link UK Dividend Monitor Q4 2022, and the group expects dividends to grow again in 2023.
It is possible to underestimate the power of this growing income at times when inflation is benign, but as the world enters a period of structurally higher inflation, it may prove more important.
Investment trusts have a particular advantage in protecting dividends in line with inflation. They can reserve income during buoyant periods and pay it out during more difficult periods. The Trust currently has revenue reserves, which allowed it to maintain its dividends to investors during Covid and pay a rising income over time.
The long-term growth of stock markets
Building long-term wealth is difficult. It is an uncomfortable truth that many people don’t save enough to ensure they have financial security. Historically, returns from the stock market have outpaced those from bonds or cash, albeit with greater volatility in between.
The periodic drawdowns in equity markets can be a deterrent and may add to the appeal of fixed income investments. However, 2022 proved that even ‘safe’ bond markets are not immune to falls in capital. Equally, by focusing on high quality companies – I,e, those companies that are cash generative, with strong balance sheets and experienced management teams, it may be possible to manage some of the volatility associated with stock markets. There are companies that can thrive, even in tough environments.
Equity risk:The value of equities and equity-related securities can be affected by daily stock market movements. Other influential factors include political, economic news, company earnings and significant corporate events.
Flexibility
2022 has thrown up a lot of challenges. The world has entered a phase of more volatile geopolitics, while the UK has had to contend with its own domestic instability. The Trust maintains a flexible style avoiding a particular sector or style bias: over the year, we increased our exposure to the resources and power sectors in the trust in response to rising energy costs, we also increased our weighting in non-UK companies, providing a degree of diversification and additional sources of income.
Diversification risk: Diversification and asset allocation may not fully protect you from market risk.
Dividends are not bonds, and will change in response to rising or falling profitability, but by finding those companies with sound cash flows, a strong market position, pricing power and robust earnings, it may be possible to sustain a growing income over time.
For more information on the BlackRock Income and Growth Investment Trust, please visit: www.blackrock.com/uk/brig
Risk Warnings
Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.
Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.
Trust Specific Risks
Counterparty Risk: The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
Gearing Risk: Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.
Liquidity Risk: The Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair.
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[1] https://www.imf.org/en/Blogs/Articles/2022/08/01/blog-soaring-inflation-puts-central-banks-on-a-difficult-journey-080122 – IMF, 8 February 2022
[2] https://www.blackrock.com/corporate/literature/whitepaper/bii-global-outlook-2023.pdf – BlackRock 2023 Outlook
[3] https://www.linkgroup.eu/insights/publications/uk-dividend-monitor-q4-2022/ – LINKGroup: UK Dividend Monitor Q4 2022, Q4 2022
[4] https://www.blackrock.com/uk/literature/annual-report/blackrock-income-and-growth-investment-trust-plc-annual-report.pdf – BlackRock 31 October 2022
For more information on the BlackRock Income and Growth Investment Trust, please visit: www.blackrock.com/uk/brig
