The income hunt post-Brexit: where to invest and avoid

Since UK interest rates hit 0.5 per cent over seven years ago, the hunt for income has been relentless.

Income seekers were helped by the dividend boom between 2012 and 2014, as scores of UK companies reinstated their income payments after repairing the damage the financial crisis had inflicted on their balance sheets.

But since the start of 2015 dividend cuts have come thick and fast - more than a dozen FTSE 100 companies have taken the axe to their dividends over the past 18 months.

Some of these had previously been consistent payers: Tesco, one of the dividend casualties, was a decade ago considered an income staple.

This is not the only headwind. Income seekers are also facing the greater challenge of sourcing income at a sensible price.

UK DIVIDEND DILEMMA

Consistent payers, those companies that boast long dividend histories, have proved immensely popular, and as a consequence their share prices have risen and their dividend yields have been driven to low levels.

In short, whether you prefer to hold income-generating funds or build a portfolio of good value and reliable dividend shares, the outlook post-Brexit seems tougher for income seekers.

The savings market is unlikely to offer any solace. Rates are already at record lows at 0.25 per cent, and are expected to fall further.

The spectre of inflation making a comeback should in theory encourage more risk-averse savers to consider going down the stock market route. Many will naturally be drawn to the UK, which has historically been a healthy hunting ground for income seekers.

But in the current climate care needs to be taken, because the dividend outlook for some of Britain's largest companies, which provide the bulk of dividends for the overall market, looks bleak.

In the short term, however, the weaker pound may offer some respite. The currency swing, which has resulted in sterling declining over 10 per cent against the dollar since the Brexit vote, is a silver lining for big blue-chip FTSE 100 companies.

Around 40 per cent of UK companies pay dividends in either dollars or euros. In turn the translated value of all those dividends declared in dollars is boosted. According to Capita Asset Services, UK dividends will bring in an extra £4.3 billion this year as a result of sterling’s depreciation.

But Thomas Moore, manager of the Standard Life Investments UK Equity Income Unconstrained fund, describes this dividend windfall as ‘papering over the cracks’.

He points out that dividend cover for the UK market - the ratio of a company’s earnings to its dividend payouts, currently averaging 0.98 times for the FTSE 350 index - is ‘dangerously low’ and that some large cap names are having to dip into capital, or worse still borrow, in order to keeping funding their dividend payments.

‘The large-cap, more internationally focused shares that declare their dividends elsewhere will of course benefit from sterling’s depreciation. But fundamentally nothing has changed - many of these big companies have a high payout ratio, stretched balance sheets and declining cash flows, which are all warning signs for investors that trouble is ahead,’ says Moore.

HSBC and BP, both of whom declare dividends in dollars, were picked out by Moore as two shares whose dividends look vulnerable. In Moore’s opinion some businesses will use Brexit as an ‘excuse’ to cut their dividends.

He adds: ‘Firms with a dividend cover score below 1 have been taking some desperate measure to keep on paying dividends. They now have the perfect excuse to cut and blame Brexit.’

In the post-Brexit world there is a fog of uncertainty, and at such times companies tend to take a step back - stalling spending and hiring plans.

The big global businesses which happen to be listed on the UK stock market are considered to be more resilient in the tougher times ahead than smaller, more domestically focused names, which mainly reside outside the FTSE 100 index.

These giant businesses tend to be armed with big brands and intellectual property, which both help to fend off competitors that are trying to steal market share away from them.

David Lewis, one of the managers who helps oversee Jupiter’s Merlin Portfolios, says the focus should be on ‘first-class fund managers that are able to seek out market-leading companies around the globe’.

The trouble, says Colin Morton, who runs various funds for Franklin Templeton, including Franklin UK Equity Income fund, is that many of these businesses are expensive, which is reflected by their low yields of around 3 per cent or less.

Morton says: ‘Looking at firms such as British American Tobacco, Unilever and Reckitt Benckiser, the dividend growth is ticking along nicely, in the mid to high single-digit range. But the yields are well below the market average (FTSE All-Share yielding 3.7 per cent at start of August). In contrast, many of the businesses with yields above the market average were facing various headwinds, even before Brexit.

'Given the more challenging backdrop, the goal of securing 4 per cent a year purely from income generation has become tough to achieve. I think a yield of 3.5 per cent and some capital growth on top to reach a 5 per cent total return is more realistic.'

UK equity income fund managers are split into two distinct camps. Some are buying the biggest-yielding stocks in the belief that dividends will be paid, while others are playing a safer game, buying lower-yielding shares where the dividend is respectable and payouts are safe.

The average fund in the sector is offering a yield of 4.2 per cent, according to FE Trustnet.

TIME TO LOOK FURTHER AFIELD?

Given the challenges and uncertainty facing the UK market, global equity income (GEI) funds merit a closer look.

According to Stephen Jones, chief investment officer at Kames Capital, 'large global businesses that are committed to paying dividends in other currencies than sterling are the place to be' in the current environment.

But bear in mind that some of the funds in the sector have big weightings to the UK. A fund that has more than 8 per cent will be 'overweight' relative to the MSCI World index. Some, however, have up to three times more than the index weighting.

This is a concern due to the composition of the UK dividend market, which is heavily skewed towards a handful of stocks. As holders of global equity income funds are likely also to hold UK equity income funds, there is the risk of a lot of crossover, with the funds holding the same companies.

Some funds in the GEI sector, however, shy away from the UK. One example is the Mirabaud Global Equity High Income fund, run by Anu Narula.

The manager favours businesses with strong brands, but says the UK-listed companies that tick all of the boxes on his investment checklist are 'too expensive'. He instead holds Alphabet (Google and YouTube), Facebook, Adidas and Nike.

GEI Money Observer Rated Funds that have low exposure to the UK include Artemis Global Income and Murray International.

Another thing to watch out for is that many funds in the sector place greater emphasis on growing their capital rather than income. This is reflected by the fact that the average dividend yield in the sector is on the low side, at 3.2 per cent.

For those willing to venture overseas there are other income options, but each comes with a caveat. In the case of Europe, which boasts three times more dividend-paying companies than the UK market, the Brexit aftermath arguably presents more of a risk than an opportunity.

In Asia and the emerging markets, as well as Japan, there is a growing dividend culture, but fund yields tend to be lower than 4 per cent typically, which may not be enough to compensate for the extra capital risk that comes with investing in these regions.

Even lower yields, typically 3 per cent or less, are on offer from US equity income funds, due to the fact that share prices are trading at very expensive levels.

Bond funds offer yields ranging from 1.6 per cent, the average yield in the UK gilt sector, to as high as 5.5 per cent - the average for the high yield fund sector. But, again care needs to be taken. Fixed income markets have become laden with pitfalls.

NEGATIVE YIELDS FORCE RISK-TAKING

According to BlackRock, more than 70 per cent of bonds in developed-market government bond indices have yields of 1 per cent or lower, while roughly a third are below zero.

In this trickier environment, bond investors who want a high level of income are being forced to take greater risks, says Tom Becket of wealth manager Psigma.

'Investors have been pushed lower down the credit quality spectrum and it's easy to see how this can become a vicious cycle of ever-compressing yields,' says Becket.

Elsewhere, commercial property funds are another option for income seekers. Despite the sector's recent woes, various multi-managers remain fans.

The reason is that on the whole, while last month's Brexit vote may have a negative impact on both commercial and residential property prices, particularly in London, commentators do not expect reductions in rental income because there is not a supply overhang.

Have Brexit housing market fears been overstated?

5% STARTING YIELD: WHERE TO INVEST?

Some investors may be prepared to accept a lower level of income in more challenging times.

Others, however, will not, and will even be prepared to accept a lower level of total return - income and capital appreciation - in order to achieve a high starting yield.

highest-yielding-money-observer-rated-funds

High yield and emerging market debt funds offer yields of 5 per cent plus. The trade-off, however, is the greater capital risk. But for both the outlook has arguably brightened, according to BlackRock.

The fund manager's asset allocation committee notes that 'high-yield companies have shored up balance sheets by cutting capex, dividends and selling assets'.

The team adds that it is also warming up to emerging market debt 'thanks to reforms in some countries and strong demand from investors fleeing negative rates'.

As the table shows, Money Observer Rated Funds Aviva Investments High Yield Bond and M&G Emerging Markets Bond are both yielding over 5 per cent.

Some strategic bond funds also catch the eye. Royal London Sterling Extra Yield Bond, managed by Eric Holt, is yielding 7.2 per cent, while Artemis High Income and Invesco Perpetual Monthly Income Plus are offering yields of 5.7 per cent and 5.5 per cent respectively.

In the difficult environment, strategic bond funds are viewed as the best way to navigate the dangers ahead, due to the fact that the managers have the freedom to invest in any type of bond.

When it comes to equities, a small number of funds in the Investment Association's UK equity income sector offer high starting yields.

These include Premier Optimum Income (yielding 7.5 per cent), Schroder Income Maximiser (7 per cent), a Money Observer Rated Fund, Insight Equity Income Booster (6.9 per cent) and Fidelity Enhanced Income (6.5 per cent).

Each fund aims to maximise the income payout for investors. A special technique that involves selling derivatives to other investors is used in order to boost the income.

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