Income for your Isa

Thankfully, there is one bright spot for investors: equities. An equity dividend strategy focused on high-dividend companies remains one of the few ways to secure an income payment that can keep up with inflation. But with many equity income investment trusts trading at a premium to the vlue of their assets, and more than a third of open-ended UK equity income funds cutting their income payouts in 2011, choosing the right fund is pivotal.

Open-ended income funds: cutting payments

While governments and individuals are short of cash and heavily indebted, companies are in relatively good shape, having strengthened their balance sheets during the credit crunch. Many are now in a strong position to pay dividends and, according to the latest Dividend Monitor from Capita Registrars, 373 UK companies increased, started or reinstated dividends in 2011. Total gross dividends rose 19.4 per cent for the full year, and soared 26 per cent in the fourth quarter alone compared with the same period in 2010. This was the first annual increase since 2008.

Given the rise in dividends, equity income funds that focus on dividend-paying companies are therefore an obvious port of call for income-starved investors. The underlying portfolios of these funds will normally contain companies that benefit from strong balance sheets and free cash flows, and as such can afford to pay handsome dividends.

But while company dividend payouts have bounced back, the picture for UK equity income funds in the open-ended space is markedly different. According to research from IFA Dennehy Weller & Co, more than a third (34 per cent) of UK equity income funds cut their payout in 2011, with only 10 funds in this universe increasing their payout by more than 10 per cent (see the table below).

Open-ended UK equity income funds increasing payouts more than 10 per cent

Source: Dennehy Weller & Co

Notes: The table above needs to be looked at in context as a number of the payout increases are a result of rebounds from significant dividend cuts in previous years. The greatest growth in dividends in 2011 came from FTSE 250 stocks, as opposed to the FTSE 100. But these mid-cap stocks slashed their dividends more drastically in 2009. The mid-cap bounce partly explains the increase for Axa Framlington Monthly Income Fund, which has a quarter of its portfolio in small- and mid-cap companies.

"If you cast your mind back to 2009, many fund managers found that they needed to 're-base' – ie, cut payouts – because they had previously relied too much on banks. But in 2011 there were no such excuses. While one or two exceptions can be positively explained, for fund managers to be still tinkering with payouts on this scale is not acceptable," says Brian Dennehy, of Dennehy Weller & Co. He highlights Threadneedle UK Equity Alpha Income (cutting the payout by 12.70 per cent), SWIP UK Income (a 9.51 per cent cut), Premier Income (8.99 per cent) and F&C UK Growth & Income (8.65 per cent) as some of the worst culprits.

Mr Dennehy says the main reason for the dismal payout growth is that some managers still juggle stocks with a total return priority, rather than prioritising payouts. "The equity income sector remains split between true income-focused funds and those who target total return, whether they openly admit it or not. Investors need to be clear which they are buying," he says, suggesting income investors focus on funds with a good track record of payout growth and an emphasis on income rather than total return, such as the JOHCM UK Equity Income and Schroder Income Funds.

"Those investors who do have a total-return objective should stay defensive and invest in funds with large-cap defensive stocks and an aversion to banks, such as the Invesco Perpetual Income Fund," adds Mr Dennehy.

Equity income investment trusts: too expensive?

While open-ended income funds have cut payouts, many investment trusts have a proud history of unbroken dividend growth and will go to great lengths to maintain this record. In 2011 there were 15 funds that boasted over 25 years of year-on-year dividend increases. At the top of the list is the City of London Investment Trust, the origins of which can be traced back to 1860. The trust has managed to increase its dividend every single year since 1966.

Another income attraction of investment trusts is their ability to 'smooth' income payments – see the extract below from my recently published book, The Search for Income, for a more detailed explanation on how this process works.

Given investor demand for income, many good equity income investment trusts are currently trading at premiums to their net asset values (NAV). Buy shares in City of London and you will pay 3.5 per cent more than the value of the shares on the open market. Go for the Merchants Trust and the premium is 2.9 per cent. Of course, no one wants to be overpaying for an investment, but there are those who argue that, given the current demand for income, and the likelihood of this continuing for some time, these premiums may be justified.

"In a world that everyone expects to be characterised by low growth, the importance of dividends becomes more significant as they will represent potentially a major part of the return. If this scenario does persist over the next five years, then investments that generate a solid income will be in demand, assuming that interest rates remain low, as seems likely," says Tim Cockerill, head of collectives research at Rowan Dartington. He adds that investment trusts trading at net asset value (NAV) or at premiums looks likely to continue for some time, and can even be justified; "providing you don't pay more than 2-3 per cent over NAV, then I think investment trusts remain an option."

US equity income & baby boomers

There is also a school of thought that expects the demand for income-paying investments to be driven further by the retirement of the baby boomer generation. The impact of the boomers and their collective buying power can be linked to increases in asset markets over time. In the 1970s, when they were in their early 20s, the prices of goods and services increased sharply; in the 1990s, when they reached their 40s, the stock market rose; and in the early 2000s, as they reached their early 50s, the housing market boomed. Now, as this generation retires and their focus shifts to preserving capital and drawing an income from their accumulated wealth, the demand for investments providing a decent income return that factors in inflation is likely to increase.

The impact of a retiring baby boomer generation is particularly evident in the US, where American companies are under pressure to increase their focus on dividends as tens of millions of baby boomers begin to retire with insufficient funds.

Changes to US taxation rules also means that the return of capital through dividends has become an increasingly attractive proposition. "Dividend payments, historically, were taxed at a higher rate than capital gains in the US, penalising companies that returned value to shareholders through dividends," explains Andrew Johnston, fund analyst at Brewin Dolphin Investment Management.

Mr Johnston continues: "With the S&P 500 yielding just over 2 per cent at present, it may not be as high as other markets, but as the world's largest economy it provides access to some of the more dominant franchises and innovators across a broad spectrum of sectors."

Funds such as the Legg Mason US Equity Income Fund, JPMorgan US Equity Income and Jupiter North American Income look to tap into the increasing inclination of large US companies to reward shareholders via dividends.

Adam Gent, head of UK Sales at Legg Mason, says: "With 76m baby boomers about to retire – and institutional investors such as pension funds switching in greater numbers to dividend strategies – we believe we are at the start of a long trend that will see the US market become a fertile hunting ground for income investors."

Go global and go east

The traditional home for income investing has been the UK and continental Europe, and this is where a greater proportion of income funds still operate. But with a growing number of global income funds and regional income funds in places such as Asia, investors can build a much more diversified and robust portfolio.

One of the biggest criticisms of UK equity income funds, both open-ended and closed-ended, is that many of these funds look similar under the bonnet given that 50 per cent of all UK dividends come from only nine companies.

"The UK stock market contains 123 stocks with yields in excess of 3 per cent, while the rest of the world contains 879. With more than seven times as many opportunities around the globe, income investors must spread their net wider," says Mr Dennehy.

Furthermore, while UK equity income slashed payouts, global income funds increased their dividend payouts last year by 10.68 per cent on average, with only two funds cutting their payouts by more than 3 per cent – Sarasin International Equity (cut by 6.55 per cent) and Henderson Asian Dividend income which, despite a 6.82 per cent cut, still has a higher than average yield of 5.9 per cent. The table below shows global income fund's dividend payouts.

Global income funds comparison of dividend payouts from 2010 to 2011

Source: Dennehy Weller

Of the funds in the global income universe, Mr Cockerill favours the M&G Global Dividend and Newton Global Higher Income. "Their approaches are very different but both offer exposure and diversification away from the UK," he says.

Asia income funds is another exciting area, with the region increasingly paying a larger portion of overall global dividends. "Traditionally known for its capital growth potential, Asia has firmly embraced the dividend culture," says Mr Johnston. "This is a reflection of the strong financial position of companies and countries in Asia and an increasing focus on shareholder returns. Having suffered their own financial crisis in 1997, Asian companies and governments went through the deleveraging then that the west is struggling with now. Payout ratios on dividends are around 40 per cent of earnings and were as high as 60 per cent in 2008-09."

The interest in Asian income is reflected in the premium the three Asian income investment trusts – Schroder Oriental Income, Henderson Far East Income and Aberdeen Asian Income – have been demanding for more than a year now. In the open-ended space, Newton Asian Income, which yields over 5 per cent and provides capital growth, is a firm favourite. "As an income fund, it will naturally lean to the defensive, which should be reassuring given the volatility of the Asian markets, which fluctuated between -1.8 per cent and 15.9 per cent in 2011," says Mr Johnston.

Alternative income

A report published by JPMorgan Cazenove says that, given continued equity market volatility, uncorrelated or alternative income appears an attractive proposition, offering genuine high yields and low correlation to broader stock markets. The report highlights that the funds with the highest yields are those investing in property, debt instruments and infrastructure.

Property investment trusts are offering a higher yield than gilts or equities, and with investors taking notice, discounts have narrowed markedly. But, as we highlighted in last week's fund tip, attractive options remain, such as Picton Property Income.

Infrastructure investment trusts also offer attractive yields and are good investments during times of inflation. However, all the investment trusts with exposure to this asset class – 3i Infrastructure, HICL Infrastructure, GCP Infrastructure, International Public Partnerships – are trading at significant premiums to NAV, making them expensive for investors to access. An alternative would be the open-ended First State Global Listed Infrastructure Fund, offering a yield just shy of 3 per cent along with attractive global diversification.

Given investors' thirst for yield, the expectation is that fund-raising for alternative income will continue to dominate new issuance in the near term. In most cases the asset class is niche and requires a high degree of understanding – for example, new issues in 2011 included NB Global Floating Rate Income (leveraged loans), Doric Nimrod Air Two (aircraft leasing) and Duet Real Estate Finance (mezzanine property financing).

Another new issue in 2011 was Carador Income, a closed-ended fund that invests in CLOs (collateralised loan obligations), which are effectively diversified pools of senior loans. The fund boasts a dividend yield of around 15 per cent while providing strong downside protection in an uncertain economic environment – CLOs' underlying loan investments pay floating rate coupons, which means that income is positively correlated with interest rates and inflation over the long term.

"We invest in loans and loans have to pay interest. These sit at the top of the capitalist structure. The fund has a low correlation with the rest of the market and low volatility compared with equities generally," says manager Miguel Ramos. He adds that the poor reputation of the asset class is playing in the fund's favour as it is benefiting from lower than ever valuations while defaults are very low. But the real value of the fund is in the dividends and principal returned over the life of the fund – somewhere between 2017 and 2021. The longer defaults stay low and the less they increase, the stronger the near-term cash flows will be and the higher the internal rate of return.

Another alternative route to income is Doric Nimrod Air Two Limited. The Guernsey domiciled, closed-ended fund raised £136m in July last year to acquire three new Airbus A380 aircrafts in order to lease them to Emirates on a 12-year term and has recently announced the intention to raise further capital via a 'C' share issue.

The company aims to mirror the transactions carried out by the previous two funds, Doric Nimrod Air One (DNA.L) and Doric Nimrod Air Two (DNA2.L). The proceeds of the 'C' share offering will be used to purchase the aircraft and then lease them to Emirates. After the running expenses of the fund and fixed costs of the loans, the fund will target an annual yield of 9 per cent, paid quarterly. The loan should amortise over the 12-year term and it is expected that the aircraft will be sold at that point. Although depreciation history on this new model of Airbus is not available, management's conservative base case assumption of residual value would provide a final return of capital well in excess of cost.

Key risks of this investment, according to Mick Gilligan at stockbroker Killik & Co, are a default by Emirates, significantly greater depreciation than expected and an inability to dispose of the aircraft at the end of the term. "However, all things considered, the attractive 9 per cent yield and the capital growth potential are more than sufficient compensation for these risks.

"This is an attractive investment, particularly for investors that require income, and appropriate for a small allocation in portfolios," he adds.

The prospectus is expected to be published in mid-March, with the 'C' shares due to list at the end of March. The expectation is that the four planes will be bought and delivered to Emirates between August and November 2012. Based on this timetable, a small dividend will likely be paid in September 2012, with the full 9 per cent dividend expected to commence from the end of the year.