UK income returns to favour

Unfortunately, safe and steady income has been hard to come by this year. That's partly because of long-standing low interest rates, which means cash offers little by way of return, and has dragged the payout profile of other asset classes down with it. Bonds and equities have all seen yields fall into line with record low rates over the course of the year.

That's a situation unlikely to change much this year, even though raising rates would be the natural response to the signs of rising inflation we're now seeing – a majority on the MPC believe that upward inflationary pressures remain temporary, and that raising rates would threaten an already fragile recovery. UK growth forecasts from both the OECD and IMF have been revised downwards, and the impact that spending cuts could have on future growth aren't yet clear, although the government has been repeatedly warned that they could hinder economic progress.

With poor rates on offer from most savings accounts (see box below), investors will need to continue looking elsewhere for income this year, although the dash for safe, income bearing assets throughout the turbulence of the last two years has rather narrowed their options heading into 2001.

Ten-year gilt yields fell to a record low of 2.94 per cent in October as fears that the UK would embark upon a new course of quantitative easing took hold. It didn't, and gilt yields have since recovered to nearer 3.4 per cent, but with inflation stubbornly high that's a real return of virtually zero – you need a return of at least 4 per cent to break even against inflation. The situation is even worse for other commonly traded government debt instruments such as US Treasuries or German bunds, which respectively yield 2.9 per cent and 2.8 per cent. Given such economic uncertainty, that's a price more cautious investors have been willing to pay – why put money into a high yielding asset like equities if a subsequent period of market weakness puts a severe dent in the value of the underlying asset? Gold's dramatic rise this year is clear evidence that many investors are happy to forego income altogether in favour of the security gold apparently offers.

But as we've seen lately, government debt isn't quite the safe haven many thought it was, although yields in more stable government debt are low, the eurozone crisis is seeing bond yields in some of the region's more economically challenged members shoot up as investors dump sovereign debt. This could well be the long awaited signal of air escaping from what many have viewed as a bond bubble, driven by huge inflows into global bond markets in recent quarters, not least banks stuffing their balance sheets full of investment grade paper. "We fear that even at the European core bond markets may not be ring-fenced if the region's sovereign debt crisis goes viral," says Jeremy Batstone-Carr at Charles Stanley.

Corporate bonds may be an alternative, and the launch of the London Stock Exchange's bond trading service means it's never been easier for retail investors to buy them. "There is still a great deal of money in the system looking for a return and corporate bond flows are enjoying sizeable inflows," says Jupiter fund manager Ariel Bezalel. Part of the attraction is that efforts by UK companies to cut costs and investment, thus improving cash flow and reducing leverage, means that default risk is low. There are certainly some corporate bond bargains still to be had.

But if this year there is an acceleration in inflation, holding non-index linked government or company paper will see your capital value eroded anyway. You may be guaranteed the issue price if you hold them to redemption, but unless they offer an index linked element, the face value is worth less each year. At least equities have a chance of keeping pace with inflation, and some of the yields on offer are still competitive even against some of the riskier government bonds. Considering the recent troubles in Greece and Ireland, would you rather put your cash in Spain (whose 10-year bonds currently yield 5 per cent) or Scottish & Southern Energy?

For what it's worth, I'd choose Scottish & Southern any day of the week, although with its shares having moved up a mere 4.5 per cent this year, the addition of a 6.2 per cent dividend yield adds up to a return that comfortably beats most other income producing asset classes. And, while the average yield across the FTSE 100 is just 3 per cent, we'd suggest that there are still plenty of similar income opportunities for stock-pickers in mature, defensive industries such as utilities or telecoms.

That's not to say equity dividends are a one way bet. Dire predictions over the UK's dangerous concentration of dividend payers proved prescient after BP's Macondo disaster saw it cut its dividend, including a third quarter payment that had already been approved. After the loss of banking industry dividends in 2008, that meant five consecutive quarters of falling overall payouts, but the underlying picture is much healthier. Excluding the effect of BP's cancelled dividend, payments in the third quarter increased at their fastest rate in two and a half years, climbing 13 per cent according to Capita Registrars.

This bodes well for UK dividend prospects in 2011. Capita's full-year forecast of £55.7bn for the aggregate payouts of UK-listed companies is down 5 per cent on 2009 and well below the peak in 2008, suggesting there is further headroom for growth as the economy continues to recover. BP has indicated that it will resume payments, and analysts speculate that the new payout could be pretty chunky, by way of an apology. Lloyds is also expected to reinstate dividend payments next year, but given the latest European debt crisis I wouldn't be rushing to buy the shares in expectation of that eventuality. Even though it will be a major contributor to the 65.8 per cent increase in dividends in the UK bank sector this year – and could account for 4 per cent of total UK dividends – a lot could go wrong between now and then.

In fact, much of the talk around equity income this year has turned towards the idea of seeking dividend growth, with many managers dismissive of the idea of chasing high yield shares. Water shares, for example, may offer high yields, but we know that their dividends will only rise, in real inflation adjusted terms, in low single digits in the coming years. Leading income fund manager Neil Woodford – who has a reputation for being in the right place at the right time – recently dumped his stake in Severn Trent, complaining that regulator Ofwat wasn't allowing the industry to generate adequate returns. And shares in the sector have climbed sharply this year after the conclusion of the Ofgem review last year. Mr Woodford is instead sticking his money in another high yielding industry, pharmaceuticals.

Unlike water shares, pharma stocks including Glaxo and AstraZeneca have remained in the doldrums this year. He's also built up a chunky holding in Switzerland's Novartis, highlighting the larger opportunity open to investors who are prepared to look further afield for income in 2011.

But after outpacing UK dividend growth this year, rising 10.3 per cent against the UK's flat performance, European payouts are forecast to climb at 'just' 9 per cent this year versus a 17 per cent increase in the UK. And with the double whammy of QE2 and Eurozone debt fears, foreign exchange risk is not insignificant.

With that in mind, UK defensive blue chips may be the best bet for income seekers. As Charles Stanley's Batstone-Carr says, "those companies offering reliable free cash generation, low financial leverage and a commitment to progressive dividend policies should continue to find favour with those investors seeking alternatives to more traditional interest-bearing savings deposits."

Safe income shares