Expect more distribution cuts from monthly income funds

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.