The hunt for income

The waiting is finally over and we have an interest rate rise. But before anyone gets too excited about the fact that rates are now at their highest level since March 2009, it’s worth reflecting on what that level is – 0.75 per cent is still remarkably low by all historical standards. Savers certainly aren’t going to get rich any time soon.

In other words, the search for yield goes on; advisers and their clients are going to have to find other sources of income for some time yet. In that context, new data from Link Asset Services, which monitors the dividends paid out by companies listed on the UK stock market, offers some respite. It says dividend payments were up by 7.1 per cent during the second quarter of the year compared to the same period of 2017, hitting a record high of £30.7bn.

It’s not all good news, however. For one thing, this data covers only underlying dividends, excluding the special dividends companies sometimes pay – following a corporate event such as M&A activity, for example; on that measure dividend payments were slightly down in the second quarter.

More fundamentally, the sustainability of dividend payments at their current levels is questionable. Link is now predicting that underlying dividends will be up 6.9 per cent year-on-year in 2018, but the dividend cover ratios of many of the highest-yielding stocks on the market look increasingly stretched. Dividend freezes or even cuts look increasingly likely, particularly if companies struggle to generate additional earnings in an uncertain economic climate where Brexit risk weighs increasingly heavily.

The reality for investors turning to equities for income is that dividend payments tend to be lumpy. Special dividends come and go – and certainly can’t be relied upon. And the ability of businesses to keep paying ordinary dividends waxes and wanes according to the economic cycle.

Enter the investment companies sector. Right now, the 30 or so funds in the UK Equity Income sector offer an average yield of around 3.6 per cent; that looks pretty competitive with interest rates where they are – and many funds offer considerably higher rates of income.

However, it’s not so much the level of the yield on offer from investment companies that should give income seekers pause for thought; rather it is the ability of funds to smooth out dividend volatility that is most enticing.

Investment companies can achieve this goal in a number of ways. Importantly, they are allowed to build up dividend reserves, keeping back some income earned in good years for receipts in order to fund pay-outs in more challenging times. They also have the option of paying income from capital, rather than income generated by the underlying portfolio.

It is this flexibility that allows so many investment companies to increase their dividends year after year – 20 have now done so in each and every one of the past 20 years. For income seekers seeking certainty about the yield they can expect to receive, this is invaluable.

Finally, note that the current rules allow savers to earn up to £2,000 of dividends with no tax to pay each year, but for those above this threshold, all investment companies are permissible holdings for ISAs. ISAs therefore offer a means to ensure savers receive all the yield on offer from an investment company with no tax deducted.