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27 November 2015

David Prosser discusses options for income-seeking investors in 2016.

In these desperate times for income-seeking investors, the growing dividend income on offer from UK equities has provided some compensation, at least for those prepared to countenance the risks of stock market exposure. But while 2015 looks set to be a strong year for pay-outs from UK companies, the dividend gravy train could be about to come off the rails.

Capita Asset Services, which has just published its third-quarter analysis of UK dividends, now thinks pay-outs in 2016 will total £89.8bn, up just 3% on the £87.2bn it expects to have been distributed by the end of this year. One issue is that this year’s totals have been artificially boosted by sizeable one-off special dividends from large companies including Lloyds Banking Group and Direct Line. More seriously, however, the profitability of many businesses, particularly in the crisis-hit resources sector, has taken a dive. Companies ranging from Glencore to Tesco and from Standard Chartered to Sainsbury have even announced dividend cuts.

“Profits are lower relative to dividends than at any time since 2009,” warns Justin Cooper, an executive at Capita. “We have seen some of Britain's biggest dividend payers announce drastic cuts for the year to come, with the prospect of more to follow.”

That alert is underlined by analysis published this week by the broker Canaccord Genuity. It says the level of dividend cover that large companies currently enjoy is at its lowest level since the turn of the century. Large-cap companies’ earnings now stand at just 1.2 times the dividends they’re paying out, Canaccord Genuity says. That does not bode well for 2016.

So where does that leave investors looking for income next year – particularly now that the Bank of England is signalling that it doesn’t expect, after all, to begin raising interest rates during the early part of 2016?

Well, it’s worth noting one finding in Capita’s research. It points out that mid-cap companies (defined as those in the FTSE Mid-250 Index) continue to outperform larger stocks, with a 30.8 per cent rise in pay-outs this year against 4.1 per cent from FTSE 100 companies.

One reason for this is that mid-cap companies are more likely to be domestically focused than exposed to global economic themes, which currently include the headwinds emanating from the slowdown in China. But also, the FTSE 250 includes a sizeable number of investment companies, which have a strong track record on dividend payments.

This is not to say that closed-ended funds are immune from a dividend slowdown. If the companies in their portfolios pay lower dividends, or fail to increase pay-outs, the income these funds receive will naturally take a hit. But the investment company sector enjoys a unique advantage in this regard – a closed-ended fund is able to maintain reserves into which it can dip to fund distributions to its own shareholders in years when dividends disappoint.

It is this facility that has enabled so many investment companies to increase dividend payments year after year, through good times and bad. No fewer than 10 funds have raised their dividend every year for the last 40 years – and many more have long-term records of doing so.

Canaccord Genuity points out that investment companies’ ability to retain income in good years in order to build those reserves has given the sector tremendous resilience – just one equity income fund cut its dividend during the financial crisis, for example. “The current level of dividend cover and revenue reserves, combined with the experience of the UK equity income investment companies during the global financial crisis, gives us a great deal of comfort regarding the sustainability of dividends [in the closed-ended fund sector],” Canaccord Genuity says.

Maybe there is still hope for income investors in 2016 after all.