With frequent announcements of dividend cuts by companies, it is easy to see why the UK Equity Income sector is losing popularity. But many funds in the sector are still paying attractive yields
As savings rates dry up and the stock markets continue to take a pounding, millions of savers and investors are looking to replace income they have lost.
Overwhelmingly, they are turning to corporate bonds, with a record £1bn ploughed into the sector in January, according to the latest figures from the Investment Management Association.
In the same month, the UK Equity Income sector saw a net inflow of just under £112m.
It is not difficult to see why corporate bonds and not equity-income funds are the flavour of the month. Investment-grade bonds that were paying a pittance a couple of years ago are now paying 7% plus.
And while there are concerns that many investors are blinkered to the risks of corporate bonds, they are - at least - considered safer than equity-income funds. While the average corporate-bond fund has lost 13% over the last year, the average equity-income fund is down by a third, according to Morningstar.
And although equity-income funds are paying attractive yields of 5%-6%, dividends are being slashed everywhere as companies struggle to cope with the recession.
A figure which has caused not little concern is that 10 companies are paying 60% of the dividends. To many it will be a stark indicator of just a few sources of reliable dividend income out there.
But Tineke Frikkee, who runs Newton High Income, dismisses these concerns. "I really do not think it is much of an issue. I do not think it has actually changed that much from a couple of years ago - but people did not talk about it then. The top 10 firms represent more sectors now - providing more choice."
She adds: "The yields we are seeing are historic - and clearly there have been lots of dividend cuts. But it depends where you are getting the yields from."
It is hardly surprising that Frikkee has a more positive take on things, having had a rather more successful credit crunch than most of her counterparts. This is largely through being underweight in banks and mining companies and overweight in more defensive companies such as utilities.
The fund grew its interim dividend by 6% in December and Frikkee says it is on track for the same in June. Its total returns were down 23% over the last 12 months, making it the eighth best performer in the sector.
"Defensive positions will continue to outperform for some time," Frikkee says. "Sticking to FTSE 100 companies with a strong balance sheet and a safe dividend is a sound strategy. Only when markets start to recover will these firms look too defensive and we will start to move up the risk scale. We believe the bear market will be longer rather than shorter and we will start 2010 with a very similar portfolio."
Frikkee insists equity income is more important than ever in the current environment. "People are getting nothing on cash deposits and need to move up the risk scale," she says. "Corporate bonds have become the flavour of the month and they certainly need to recover before equities can. But this deflationary environment has created a perfect storm for corporate bonds. Investors have become overexcited about them and don't realise the risks that they could lose money over five years."
She adds: "Now is a good time to go into equities if you are brave enough, with defensive companies still looking cheap."
But with even some of the most respected fund managers losing their way in the downturn it is hardly surprising that other investors do not share Frikkee's enthusiasm.
Anthony Nutt, manager of Jupiter's Income and High Income funds, is markedly more downbeat. He says: "There is a risk of over-concentration in equity-income funds rather than overvaluation in these companies as investors seeking income find there is a decreasing pool of companies paying dividends. However, the financial crisis has taken such a toll on sentiment that even when such sectors return to favour, investors are likely to take a more cautious approach to their investment. They will want to see a much more attractive return as the price of putting money in those areas where asset values have been hardest hit."
Nutt is refreshingly sanguine about where he has gone wrong over the last year or so. The £2.7bn Income fund is down 32% over 12 months. Meanwhile the High Income fund - top quartile since launch in 1996 - has dropped 23% compared to an average fall of 25% for the UK Equity and Bond sector, according to Morningstar.
"We could have been more defensive," he says. "The decision to get out of mining in late 2007 and early 2008 hurt us in a big way and accounts for the largest bit of underperformance. There were errors of judgement in retaining highly leveraged sectors, particularly in the media. For example, since we bought Yell we have seen it all the way to the top and all the way back down to the bottom."
Having said this, Nutt is keen to point out it is not all doom and gloom, with Admiral - one of his holdings - increasing its dividend by 20% earlier this month.
And he is confident that there are still other attractive income stocks out there - most notably from good-quality, large companies in defensive sectors such as oils, tobacco, telecoms and pharmaceuticals. He says: "There are plenty of income stocks on attractive multiples as deleveraging continues to weigh down on share prices. The 'big chase' for income is still in its infancy as investors have only recently started to realise the impact falling interest rates are having on their savings."
Nutt does not believe we will start to see an economic recovery until the latter half of 2010, no matter how many billions of pounds the British Government pumps into it. He says: "It will be very much a US consumer-led recovery. Other economies will not bounce back until the US consumer feels better about job security, debts, etc'.
Until then, equity-income fund managers will continue to have their work cut out.
Mark Barnet, manager of Invesco Perpetual UK Strategic Income, says one of the keys is looking for firms that have adapted to the current downturn - not purely those with strong balance sheets.
"What people felt was a safe income was not safe," he says. "They ended up in high yield and that is never sustainable. I do not look for dividends per se but look for dividends which have the potential to grow. These firms not only have strong balance sheets but will have developed their business models to cope with lower levels of sales, for example."
To an extent, this strategy appears to have been paying off. Barnet's fund is the seventh-best performer in its sector over 12 months - down 23%- and has benefited from large holdings in utilities, tobacco and oil , and being underweight in banks and life companies.
"I find it amazing that since the beginning of the year the best-performing shares have been cyclical, including housebuilding services, with mid-cap outperforming more defensive FTSE 100 stocks by 15% this year," he says. "But I think there is still a lot of value in the defensive areas of the market. These are areas I believe will continue to perform well in the downturn."
