NIE's Distribution at Greater Risk as Outlook for Growth Stocks Remains Murky
The Virtus Equity & Convertible Income Fund (NIE) invests in a mix of growth-oriented common stocks and convertible securities issued by companies like Microsoft (MSFT), Apple (AAPL), and Tesla (TSLA).
From the depths of the great financial crisis in 2009, the stock prices of growth companies surged as historically low-interest rates allowed businesses to keep pushing risks into the future – allowing NIE to cover its distribution with capital gains comfortably.
This seemingly risk-free environment was especially evident during the pandemic rally that peaked late last year, around when NIE increased its payout by over 30% for the fund's first hike since 2014.
But over the past year, these risks have been pulled back to reality as steadily rising interest rates have squeezed the growth companies NIE favors, and stock prices have plummeted.
As a result, NIE's net asset value (NAV), or the value of the fund's investment assets net of any liabilities, has dropped more than 30% in the last year – making last year's distribution hike look ill-timed.
Source: Simply Safe Dividends
The fund's NAV per share is down around 2019 levels, while the distribution is 30% higher.
As a result, the fund now distributes 8% of its NAV yearly to shareholders. This distribution rate is the hurdle NIE's total returns need to exceed going forward to cover the distribution and stop NAV from eroding further.
Before the pandemic, NIE's distribution rate sat around 6% of NAV. Barring a quick recovery in growth stocks, which may be unlikely as the Fed appears intent on keeping interest rates high to fight inflation, NIE may find it prudent to return its distribution rate to pre-pandemic levels.
Cutting the payout by around 20% would move NIE's distribution rate back to about 6% of NAV. This would create a more sustainable distribution based on the fund's long-term performance and recognizes that future returns could be higher whenever the market recovers, though unlikely to return to 2021's frothy valuations.
Recognizing the fund's increased pressure to rebase the payout assuming the fallout in growth stocks persists with higher interest rates, we are downgrading NIE's Dividend Safety Score from Borderline Safe to Unsafe.
There has been just one distribution cut in NIE's 15-year history, back in 2009, following the only other material decline in NAV when the fund lost around 50% of its value leading to a similar amount cut in the payout.
While the fund's current losses have yet to match those seen in the great financial crisis, management may not want to wait much longer before right-sizing the distribution considering the growing risks of a recession.
If we held shares of NIE, we would consider reallocating those funds into a CEF with a safer distribution and less exposure to the pressures imposed by rising interest rates.
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