Why the old Prudential now has a dividend yield of 10.88%. (And should you invest in it.)
by Doug Brodie
Legal & General is at 8.18%, Aviva is at 7.38%, Phoenix is at 9.51%: if you held all four of these insurers equally in your ISA those income yields average at 8.99% per year. Two obvious questions arise – why, and should you?
The why
This starts with 2008 – back then investment banks provided ‘warehousing’ facilities for corporate bonds (the bond simply being an amount of borrowing/debt owed by the corporate). They held these on their balance sheets taking comfort from the credit strength of the issuers – companies like other banks (JP Morgan, Lloyds, BNP Paribas etc), insurers (AXA, Allianz, AIG, Aviva), and corporates from Danone to Disney, Visa to Vodafone. Bonds are traded on the stockmarket, however there is one key difference – the minimum sums (or lot size) tend to be very large so that only institutional funds can buy them, normally in $100-$200,000 lot sizes.
As the market prices of the bonds rise and fall, so the difference between what the bank warehouse paid for them and the current value is either a profit or a loss, and that profit/loss is an actual entry of the bank’s balance sheet. The valuations are set by the market trades every day – what’s known as mark to market – and in 2008 the bond values fell so much they reduced the balance sheet values of the banks so much they almost collapsed, so the solution was to remove ‘mark to market’ and banks were allowed to carry the bonds at the prices they had paid. (Note from the Ed: this is a layman summary, not a technical treatise, so apologies to bank specialists reading this).
Insurers need income assets, so they buy bonds; SVB failed in the US, Credit Suisse failed in Switzerland, in times of panic institutions sell assets to increase their cash holdings so their balance sheet values can’t fall. But hang on, if the institutions are all raising cash by selling bonds, and the only buyers for bonds are ….. the institutions then there is no one on the other side of the trade to keep prices up. There’s some other commercial ingredients behind how our insurers have been operating, however this is how we end up with our household name insurers yielding 9% per annum.
Should you buy?
I was talking to a new client this week, a retired architect, who told me of his one self directed foray into buying on the strength of a dividend yield: he bought shares in Taylor Woodrow but soon discovered that housing cycles destroy both shares and dividends.
We split the portfolios of trusts and funds apart when constructing your/client portfolios for various due diligence reasons, and to check they are not all investing in the same areas. The largest shareholder of M&G is Vanguard, the largest active manager is Janus Henderson.
Today’s M&G is actually the former UK and European business of the Man from the Pru, the home of the £90 billion With Profits fund.
The average number of holdings in the trusts we use is circa 60, with F&C’s £5bn spread across roughly 400 firms. Lowland holds the key insurers all together so that diversification plus their existing embedded reserves of £8.2m makes this trust a much more conservative option than buying the shares. (Though we still don’t recommend it as a holding for our clients).
Most importantly, don’t forget that the term ‘Black Swan’ exists because they are real, and they do appear. Here’s two brilliant examples:
In 2013 the Co-op’s bank effectively went bust, and a nation of retired pensioners were holding income paying preference shares – was there ever a more ‘widows & orphans’ preference share?
In 2018 Aviva announced it was going to redeem its high yielding preference shares, another stalwart of the nation’s post-war pensioners. The uproar forced a stop to the proposal.
Is there a potential Black Swan lurking in the ponds of M&G, L&G, Phoenix et al.? Who knows, but would you want to gamble your retirement income on it?
The difference between your pension, and a pension fund: why they are not invested in the same way.
Reading from above, bonds are great for income so pension fund managers buy them for the pension funds.
A pension scheme has a mix of active employees paying money in, retired employees drawing income out, and deferred employees doing neither, just waiting till they retire.
A scheme has monthly income from the employer and employees, and therefore it has positive cashflow to payout to retired employees. Add to that premium income some fixed income from bonds and the cashflow is nicely balanced.
The beneficiaries of the schemes will normally range from early 20’s to late 80’s, and older, and the scheme therefore has to exist and invest over several generations.
Your pension has no income other than from investments and is only ever a) deferred or b) in payment, and only needed for one generation – yours.
The cashflow requirements are totally different, which is why institutional research intended for pension schemes is no use for single, retail pensions.
Plus, pension funds have their own restrictions and limitations – in general a fund will only be allowed to hold <5% with any one asset, and in looking at bond funds you’ll see huge diversification. The M&G Optimal Income fund is £1.4bn and holds 253 different bonds and assets. It yields 4.04% if you own it. In comparison the average yield of all the trusts in the UK equity income sector is 4.08%, so why use a bond when the trusts give much greater diversification, plus the inevitable potential for capital growth?