Boost your income with American yields

The US, where the average yield on the S&P 500 at 2.21 per cent is relatively low compared with the FTSE 100, currently on 3.66 per cent. But global income investors such as Stuart Rhodes, manager of the M&G Global Dividend Fund which has a third of its assets in the US, see things differently, arguing that the US is polarised. "You have to look at how it is broken up and then you can find a good yield," he says. "If you take out technology and financials the yields are much higher. There are wonderful opportunities in every sector with the exception of these two – and even then there are opportunities in financials if you go down the cap scale.

"The best dividends tend to come from the best operators in the industry, who have the best return on capital. More often than not, those best-in-class operators are to be found outside the UK. The US is the leading light."

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The prospects for US dividends continue to look good.

"US publicly traded companies, bolstered by record profits and significant cash hoards, are increasing their dividends at the fastest pace in seven years," says Clare Hart, portfolio manager of the JPM US Equity Income Fund. "So far this year, 226 companies have upped their dividends, while only four have cut theirs. On a dollar basis, corporations added $39.8bn to dividends in the last three quarters. That's 50 per cent above the $26.5bn added for all of 2010. Such companies should emerge even stronger once markets return to normal and be positioned to provide enhanced shareholder value and persistent income streams over time."

Mounting US demand for retirement income is also forcing corporate America to adopt a dividend-driven pay-out policy, as tens of millions of baby boomers begin to retire with insufficient funds. "It is already clear companies are beginning to respond to this," says Peter Vanderlee, manager of the Legg Mason US Equity Income Fund. "Microsoft, for example, recently increased its dividend by 25 per cent. But it's not just the giants doing this: we're beginning to see similar moves across the board."

US companies are healthier than they have been in decades. “Large cash balances coupled with the deleveraging of balance sheets post the 2008 financial crisis afforded companies enough financial flexibility to not only raise dividends but also to improve the sustainability of those dividends," says Mr Vanderlee. "Also, many corporations are generating healthy free cash flow which provides further support for dividends."

Valuations are low: longer-term average S&P 500 multiples have been 17 times, well above the 12 times they are nearer to at present, which Mr Vanderlee says is an opportunity for long-term capital appreciation as well as rising dividends. Rising dividends are a useful way to keep up with or ahead of inflation, especially if you are retired.

Given that many income stocks derive their earnings from overseas, the recent weakness of the US dollar has helped to bolster their earnings, and they offer the opportunity to capture global growth. Many are large and strong, so better placed to ride out a global downturn or other shocks.

US smaller companies have outperformed US large-caps significantly over the past 10 years, with the Russell 2000 returning 65.23 per cent versus a fall of 0.77 per cent for the S&P 500. "One could therefore argue that US large-caps are due a re-rating, especially in these uncertain times when safety is at a premium," says Darius McDermott, managing director at discount fund broker Chelsea Financial Services. "Small caps still trade at a premium to large-caps on a price-earnings basis but are more exposed to weak consumer spending and poor credit conditions, which may suggest that this protracted trend of small-cap outperformance could come to an end. In the year to date the S&P 500 has outperformed the Russell 2000 by about 4 per cent."

Generally looking up

US economic prospects have started to look better. "Despite the current focus on eurozone woes and talk of another global recession, a lot of US economic data has actually been surprising to the upside over the past couple of months," says Ian Kernohan, economist at Royal London Asset Management. "While recession in Europe looks to be a done deal, the situation in other parts of the global economy looks more robust."

Jeremy Tigue, manager of Foreign & Colonial Investment Trust, which has more than a fifth of its assets in the US, adds that US consumers are more confident and US banks are ahead of Europe in dealing with their problems, while the technology companies in there are world leaders.

Three US funds not specifically focused on income have also recently been launched because their managers anticipate good prospects. These are Schroder US Alpha Plus Fund, Polar Capital North American Fund and Harris Associates Concentrated US Value Fund.

An argument for diversifying away from UK equity income is that much of it comes from a few stocks, raising concentration risk. In the past few years this has been evidenced by banks scrapping their dividends and BP cancelling its dividend.

But there are 225 companies in the S&P 500 that yield more than 2 per cent and the US dividend market is broken down among its sectors more evenly than in the UK.

But nothing is risk-free

The main risk to US equity income stocks is that global growth slows and companies choose not to return the cash on their balance sheets through increased pay-out ratios. Events in Europe are likely to influence significant market movements, including further afield in the US.

The US market is more highly valued than those in the UK and Europe, and is on a higher price-earnings ratio so there are fewer yield attractions, according to Ted Scott, director of global strategy at F&C Investments.

"Value investors have had a torrid time since the financial crisis, and many growth stocks have benefited from increased commodity prices and loose monetary policy," adds Mr McDermott. "It is difficult to see any clarity on whether investors will return to the value sectors, such as the banks, or continue to seek companies that have strong earnings growth."

A market driven by strong relative outperformance in stocks which do not produce so much income could mean that income stocks underperform in a rally.

Note also that currency movements could influence returns – adversely if sterling strengthens against the US dollar.

US equity income funds

Source: Morningstar as at 2 December 2011