As Chris Evans, manager of the Charles Stanley regular high income fund says: “There will be a lot of companies who see this as a precedent, now they see it is OK for them to do it too.”
With dividends struggling, UK equity income fund managers are being pressed to find income in increasingly creative places.
There are three ways of digging out this extra income. First, they can hold overseas shares, which allows exposure to a broader range of companies, and therefore provides more choice for dividend-hunters.
The Investment Management Association rules state that a portion of the fund can be in assets that are not UK equities and a number of funds have been using this option.
Credit Suisse director and head of UK equities Graham Ashby has the freedom to put up to 15 per cent into investments outside the UK.
He says: “We have a smattering of overseas companies, so, for example, we know BT is likely to cut the dividend, so instead of holding that, we have Telefónica in Spain, which is generating plenty of cash.”
Sarasin international equity income fund manager and CIO Guy Monson says this type of move has become increasingly attractive, as overseas dividends have risen. He says: “Companies tend to have more conservative dividend policies and higher dividend cover than in the UK, so there is less likelihood of unexpected cuts.”
Second, managers are looking for opportunities elsewhere in the capital structure. This includes convertibles.
A number of hedge funds have been forced sellers of these products, so there are some bargains on the market. Ashby, for example, says: “Soco International has net cash on the balance sheet, yet its convertible is selling at a big discount to par. The gross redemption yield on that is 16 per cent.”
The equity would be considered a bit risky for the fund but the convertible is higher up the capital structure, so Ashby has bought. But he points out there can be problems re-selling convertibles, so he is choosy about those he has in his portfolio.
Evans has long-standing holdings in permanent interest-bearing shares of building societies. He says: “Credit rating agencies do not rate them but we think the balance sheets of traditional building societies are better than the banks.”
He says the limited liquidity in this part of the market means investments have to be chosen carefully. He says: “I would rather miss the plane than get too far from the emergency exit.”
Managers are also looking at corporate bonds as a portion of the portfolio. Ashby highlights the Daily Mail and General Trust, which would raise some concerns from an equity perspective, given its debts, but which is offering a 2013 bond yielding 11 per cent.
He says: “We have run a conservative scenario and it shows they can fund that and repay it.”
The third avenue open to these managers is selling covered call options on the portfolio.
This means they own the stock already and sell the option to buy on a particular date at a specific higher price (the strike price). The buyer will pay a premium up front for the option. If the stock does not rise to that level, the fund manager will get to keep the premium and not sell the stock, which will add to the income pot.
If the stock rises modestly, just above the strike price, they may break even when the premium is added into the gain.
If the price shoots up, they will not lose money, they will simply underperform.
Ashby, for example, does this occasionally, including recently with Reckitt Benckiser stock.
Premier optimum income fund manager Chris Wright does this tactically as a major part of his fund’s strategy. He says: “Selling covered call options has created a lot more income than just holding the stocks.”
The Schroder income maximiser fund writes options across the portfolio as a key part of the fund’s remit. Manager John Teahan uses the underlying stocks from the Schroder income fund and sells covered call options to hit the target of 7 per cent return.
For example, with dividends predicted to be somewhere between 2.3 per cent (according to the swaps market) and 5.8 per cent (predicted by brokers) next year, he will aim to sell options across the portfolio to generate the shortfall of 1.2 per cent or 4.7 per cent.
Teahan points out that current volatility actually helps his strategy and says: “The more volatile the share is, the higher the premium, so, in an environment of increasing volatility, I can get a higher premium if I need to or I can take the same premium but with a higher strike price.”
Peter Fuller, a research director with Standard & Poor’s says this is an increasingly common strategy. He says: “We believe there are other funds about to launch which will use covered call options to generate income and that a number of those running equity income funds will be taking on a bit of call writing.”
Fidelity International, for example, launched an enhanced income fund in February, with a covered call writing mandate.
Funds can do a bit of this within the IMA guidelines for the UK equity income sector, which has for some time allowed 20 per cent of the fund to be in assets outside UK equities.
Managers who go over this limit have fallen into the specialist sector. This means that the Premier optimum income fund and Schroder income maximiser, for example, are listed as specialist funds.
The managers are hoping this will change when the IMA announces alterations to its sector guidelines. These have been expected for some time, and at the latest count were due as we went to press.
Funds with broad call writing strategies may not appeal to everyone.
Evans says: “Over the next few years when people come to buy funds, they will be asking more questions. They do not want complex products. They want to understand what the manager is investing in.”
However, given that it is a strategy being employed increasingly by equity income managers of all persuasions, it is worth weighing up the benefits of higher income against the difficulty of getting to grips with more unusual investment strategies.
As Wright puts it: “I would prefer it if investors are encouraged to overcome any concerns and take advantage of all the opportunities rather than leaving them to invest in what they are comfortable with and possibly have to live with a dismal income.”