Expect more distribution cuts from monthly income funds

By Dan Hallett, CFA, CFP

I have been writing about Monthly Income funds for more than a dozen years.  In my 20-year career, none of my articles or comments have generated as much feedback (or as much anger) as my critiques of Monthly Income funds.  Capital market activity has made distributions less sustainable than they were a year ago.  Many funds have quietly reduced distributions while others have been more forthcoming about distribution cuts.  And if we hit even a mild bear market for stocks – which could take a year or two to materialize – more cuts are in the cards.

Two years ago I wrote about my expectation for balanced portfolios to generate 6.5% annually over the subsequent 10 years.  Back then, stocks and bond were cheaper – making prospective return potential higher than today.  Stocks are currently priced to generate 7-ish percent long-term annualized returns (before fees, taxes, impact of cash flow timing and value added/detracted) while bonds yield 2.4% annually.  Accordingly, balanced portfolios are unlikely to punch out total returns of more than 5% annually based on our recent calculations (again before fees, taxes, etc.).

This is relevant because most of the Monthly Income funds I’ve reviewed have some kind of balanced asset mix policy.  A review of appropriate distribution levels is a routine exercise at many fund companies.  For instance, IA Clarington Strategic Income Y (the original Clarington Canadian Income fund – the subject of my first article on this topic) switched to a variable distribution rate starting last month.  After spending most of its life over-distributing – and grinding its unit price to half of its initial 1996 level – the fund has finally transitioned to simply paying out its taxable income.

Another example is NEI Northwest Growth & Income A - which spent years paying out $0.96 per unit each year (i.e. $0.08 monthly per unit).  It cut payouts to $0.06 monthly per unit for 2012; and then last year did away with its level monthly cash payout.

There are certainly examples of responsible and sustainable distribution policies.  Examples include TD Monthly Income, RBC Monthly Income, Steadyhand Income (which gets top marks for proactive communication) and more recently BMO Global Monthly Income.  Some may recall my critique of BMO for both of its domestic and global Monthly Income funds among others.  BMO Global Monthly Income’s distribution sustainability is much improved.  Unlike others, it didn’t cut its payout.  Rather it has seen a sharp increase in its allocation to stocks – from about 56% several months ago to nearly 70% recently – which raises its risk but also increases its total return potential.

Investors beware.  Most of the funds I’ve seen sporting sustainable distributions have sibling funds or similar products with distributions that cannot be sustained in my opinion.  While the I and A series units of TD Monthly Income offer very sustainable cash payouts, the same fund’s series-T units pay out too much in my opinion.  Similarly, RBC Monthly Income has long had a responsible distribution policy.  But RBC Managed Payout Solution – Enhanced Plus needs to cut its distribution in half to be sustainable by my estimate.

Investors and advisors should understand the extent of a fund’s sustainability, stay on top of distribution changes and keep an eye on those ramping up risk exposure to juice returns to support monthly payouts.  Skinny bond yields and fully valued stocks will restrain total returns going forward; which will put more pressure on Monthly Income funds to take action to keep cash flowing.

   
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17 comments to Expect more distribution cuts from monthly income funds

  • Gary

    thank you for this excellent article. i recently sold my cibc mif and purchased a lot of the same securities they myself. this way i can control my distributions.

  • Thanks for your note Gary. Your chosen path is one way to address the issue I’ve written about. Another is simply to choose a fund or ETF that has a more sustainable distribution policy.

  • Paul Bonhomme

    What do you think about Sentry Select NCE 1032′s monthly distribution. I have been holding this since 2008 before they went from unit trust fund to Mutual fund. Is it sustainable.

  • Paul, NCE1032 is Sentry Diversified Income Fund series X. It pays a monthly distribution of $0.026 per unit per month and recently had a unit price of $5.396. These numbers work out to an annualized distribution rate of 5.78% per year, net of fees.

    The way that I have examined suitability in the past is to put the assessment in a gross-of-fee context. So when accounting for its 1.48% MER the total return required to support the distribution is 7.35% per year before fees. Given that it holds nearly 100% in stocks, this may well be supported by the total return.

    Income investors may not be comfortable being 100% invested in stocks. But as distribution sustainability goes, my only concern is the potential impact of volatility on sustainability (i.e. continuing payouts during steep bear markets could challenge keeping the unit price above today’s level longer term).

    Note that my above comments refer only to NCE1032 (series X). But if you’re holding series A units of this same fund the story changes. The unit price is lower (because of higher fees) and the distribution is the same.

    The end result is that series A units of this fund must return more than 9% annually before fees to support this distribution. And my guess is that it won’t be fully supported. I’d speculate, however, that Sentry won’t cut this distribution but is more likely to leave it as is and let the unit price grind down slowly. If this happens, they will need to cut payouts eventually (since a level payout + falling unit price = rising payout rate) but that could be a long way off.

  • I have been following Dan Hallett’s contributions to various Publications that deal with the world of Investors and Investments. My reason for this is quite simply his erudite plus unbiased Advice. This piece is another example of my point.
    I hope his writings will continue to be solicited, so that his Contributions will continue as well.
    Thanking you.

  • Thanks for your note Harry and for taking the time to add very kind words to our blog. I recognized your name right away from many past exchanges. Note that I’m not just a contributor to this blog but it is the official blog of HighView Financial Group, of which I am a partner and employee.

    Please keep reading! And your feedback is welcome in the comments section (or by email to me directly) any time.

  • D. Robinson

    Sentry Canadian Income Fund has a monthly distribution rate of $.0775 per unit (which equates to $.93 per unit annually). This monthly distribution rate is enticing for a retiree like myself (I am an early retiree at age 65). However, their annual distribution rate contains a return of capital ranging from $.74 in 2010 to $.28 in 2012-13. My concern is that a return of capital at this rate would result in a serious loss of capital over the long term (i.e. 10 to 15 years). On the other hand, the Fund does have a good a good rate of return history. I would appreciate your thoughts.

  • Thanks for your note and question. Return of Capital isn’t necessarily bad. It simply means that a fund is paying out an amount that exceeds the taxable income. Funds run into trouble when cash payouts cannot be supported by its total return. All of the monthly-payout funds I pick on are those with unsustainable distributions. You’ll be pleased to hear that Sentry Canadian Income isn’t one of them.

    I go simply by the numbers. And today’s distribution equates to a payout rate of just 4.7% annually based on recent unit prices. For a fund that is 100% invested in stocks, I fully expect that it will be fully supported by the fund’s total return.

    So remember that return of capital is okay so long as the total return required to support the payout isn’t too high. Sentry did exactly the right thing with this fund in terms of setting a responsible and sustainable distribution policy.

    Look back ten years and you’ll see that the distribution used to be 0.0675 per unit monthly. At July 31, 2004 that equated to an annualized payout rate of 6.8% per year (based on its unit price of just less than $12). Today the distribution is a bit higher and the unit price is north of $20.

    Performance has indeed been strong in the past. But even if stocks meet my much more moderate estimate for the future, this fund’s distribution should be just fine.

  • D. Robinson

    Thank you for your quick response. At the risk of being a pest, please indulge one more question regarding this issue.

    Even though Sentry is able to handle the rate of distributions at the present time, what concerns me is if I had to sell it in the future for whatever reason. With such a high return of capital, I envision having a drastically reduced adjusted cost base which could leave me with an exorbitant capital gains tax at a time of my life when I could least afford it. I also don’t understand why Sentry’s distributions contain such a high return of capital when its returns are so high. (I should note that I already own RBC Canadian Equity High Income Fund whose distributions contain minimal returns of capital even though it too has a generous monthly distribution of $.09 per unit.)

    As a result, I am caught between buying the Sentry Canadian Income Fund or a more conservative fund such as Mawer’s Balanced Fund which does not have monthly distributions but would seem to be a better bet to preserve my capital for the future. (Also, the Mawer’s fund MER is .96% as opposed to Sentry’s 2.7%.). Thanks for your patience and expertise.

  • You’re welcome. Think of the tax issue this way with numbers that I’m going to mentally ballpark (so don’t take them too precisely)…

    The fund has generated something like 15% per year over the past 5 years. Let’s say the fund has had an average taxable income of about 5% annually (i.e. 3% average dividend yield + about 2% per year in realized capital gains). That still leaves the majority of the return – 10% per year – in the form of accrued (or untaxed) capital gains.

    If you’re selling units to generate cash flow you’d incur some taxable capital gains with each withdrawal. All that’s happening with the return of capital distribution is that you’re effectively withdrawing cash without having to sell units and trigger annual capital gains. In other words, the small gains you’d trigger with monthly selling of units is being deferred to the point when you sell your units at some point.

    This is a true tax deferral benefit, which they’ve been able to provide to investors for two reasons: i) the total return has been significantly higher than the rate of distribution; and ii) investors continue to put money into the fund relieving the fund from having to sell stocks to fund cash payouts (which would trigger more taxable gains).

    So as much as you may hate paying the tax bill, one will only exist because you’ve made good money on this fund. As for your final comparison – i.e. Mawer Balanced vs. Sentry Canadian Income – this is tough to evaluate.

    What you’re comparing is a more conservative balanced portfolio vs. an all-stock portfolio. You must make that decision by ignoring which products you might buy. Think of this at a strategy level and use good calculators like this one from Dr. Norm Rothery or this one from Steadyhand Investments to understand the risk involved in different asset mixes.

    Once you’ve decided on an asset mix that is appropriate both for your comfort level with risk and your need/capacity to take risk, then you look for a product that fits what you need (or buy a few products you can use to effect the mix you need).

  • D. Robinson

    Thanks again for your time and expertise. It is much appreciated.

  • Paul N

    Hi Dan,

    I notice you picked a few TD MI funds above. Could you comment on TDB298 which is a series “H” monthly income fund. A bit of a high MER but a nice distribution every month. Do you feel it is sustainable, or one day also suffer the fate of the BMO MI fund?

    Thanks

    A different Paul then above….

  • Thanks for your note Paul. TDB298 is TD Dividend Growth series H. I’ll start with an illustration I find interesting (though it doesn’t quite answer your question). On TD’s website you can chart the fund both with reinvested distributions or not (i.e. taken in cash).

    To equate what you see in the chart, with reinvested distributions, the fund has produced an annualized return of 5.3% per year through July 31, 2014.

    The pure unit price, however, has fallen by 2.7% per year since inception through July. In other words, the fund has paid out more than its total return over the past (almost) 7 years. That’s the past. Your question is more about the future and I expect that the distribution will eventually continue to eat into capital over time.

    This fund invests primarily in dividend paying stocks. The current monthly distribution equates to 7.4% per year net of fees – or 9.6% gross of fees. In other words, the fund’s total return has to approach 10% per year just to keep the unit price from further erosion.

    We estimate that stocks are priced to generate future returns of 7% per year. If we’re correct, TD would have to add almost 3 percentage points of value added just to sustain the distribution. And I doubt that they’ll be able to do it.

    While the distribution is not in immediate danger, I fully expect a distribution cut at some point.

  • I should add that TD Asset Management is one of the companies that evaluates their monthly distributions every year to assess sustainability. With TDB298 they appear to have been cutting payouts as markets fall and hiking distributions in good times. Monthly payouts began at $0.099999 per unit. It was cut in 2009 to just $0.0611 per unit by early 2009. But it’s back up to $0.0759 this year.

    So the next time markets are pushed down, the distribution is likely to be cut. But even without a major decline I would expect the current longer-term declining trend to continue – ironic for a fund called “Dividend Growth”.

  • Paul N

    Thank you for your detailed reply.

    I got a bit lucky with my timing and got into this fund when it was $9.85. I’ve always reinvested the distributions, so it’s been pretty good to me until now. I would like to switch it into something that would have a similar structure with a much lower MER and be a little less volatile in a downturn.

  • Larry M

    It’s refreshing to read clear information about investment products. Just saying Thanks! Keep up the great work.

  • You’re welcome Larry. And I appreciate that you took the time to post your kind comments.

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