Mercantile set to perk up

When BP axed its dividend earlier this year it was a wake-up call for UK equity income investors. Traditionally high-yielding shares in the FTSE 100 index have been secure income plays. However, the ability of blue chips to generate income has become increasingly concentrated on a handful of stocks. So when something goes wrong for a big dividend payer, such as the BP oil spill or the banking crisis, it is a major blow. Bonds are also looking increasingly precarious for income seekers. As bond prices have soared, yields have plunged, and the argument that the bond market could be the next bubble to burst is feasible.

The Mercantile Investment Trust offers a way of securing UK-derived income away from both blue chips and bonds. The trust invests in mid-cap shares and pays a dividend that currently yields a decent 3.7 per cent. Its wider hunting ground means it can offset some of the risks of investing in mid-caps by having a diverse portfolio. Indeed, it routinely holds over 200 positions and its largest holding accounted for little more than 3 per cent of its portfolio at the end of September.

That is not to say Mercantile is immune to the problems that have beset income funds since the credit crunch. Indeed, recently the trust has not been generating enough income from its portfolio to fully cover its dividends. In its latest financial year income per share fell from 41.73p to 23.18p - significantly below the 36p dividend payout.

However, there are hopes companies will start increasing dividend payments again. Indeed, broker Evolution recently published a note saying it thought dividend-growth prospects represented a "once in a cycle opportunity". That view is based on expectations that many companies will see a substantial boost to free cash flow as a mild recovery continues. The broker also says the UK payout ratio of dividends to earning is now substantially below its long-term average, so dividends can rise.

At the half-year stage, Mercantile's return per share had already begun to pick up, rising from 13.65p to 14.27p. What's more, investment trusts can pay out dividends from their revenue reserves and Mercantile had reserves of 27.5p per share. Mercantile's board acknowledges the importance of dividends to its shareholders and has said it plans to keep its third-quarter payment for 2010-11 at 6p. The size of the final dividend will depend on the portfolio's progress, but the board adds that it will be "mindful of the substantial revenue reserve position" when making its decision.

The trust has become more defensive during the year by moving from a geared position (whereby it borrows money to buy shares) to one where it had net cash at the half-year stage. The manager, Martin Hudson, has also been attempting to avoid companies that he thinks will be hit hard by government spending cuts, such as defence contractors.