If, as is being widely suggested, the Bank of England is likely to continue tightening monetary conditions by raising rates close to 6% in its effort to combat inflation, we suspect investors are going to want a higher degree of income protection than they have so far this year.

The good news for income-seekers is the UK market is a treasure trove of high-quality, high-yielding stocks on attractive valuations.

Moreover, as a recent Shore Capital note highlights, ordinary dividends tend to be fairly solid, although not set in stone, whereas share buybacks – which until now have provided significant support for valuations and earnings – are very much discretionary and may well decline in future as firms opt to hold onto their growing piles of interest-bearing cash rather than dish it out.

RATES TO GO HIGHER FOR LONGER?

As Laith Khalaf, head of investment analysis at AJ Bell, comments: ‘The latest readings for core inflation and wage growth have come in hot, and that has spooked the market, sending gilt yields skywards and raising expectations of more interest rate hikes to come.

‘The market is now firmly pricing in an interest rate rise at the Monetary Policy Committee’s June meeting, and then four further hikes, taking us to 5.75%. A few hawkish comments from the Bank of England, or some more ugly inflation data, could easily tip those expectations up to 6%.

‘While interest rates may not ultimately hit those heights, those expectations do set market pricing in the here and now for government bonds, cash accounts and mortgages.’

They also set expectations for investors looking for income, and with some FTSE 100 stocks offering close to double-digit yields the UK is a fertile hunting ground.

Meanwhile, if inflation readings, which are backward-looking by their nature, begin to subside by the end of the year, so will interest-rate expectations.

QUALITY STOCKS ON HIGH YIELDS

Analysts Graeme Kyle and Chris Bottomley at Shore Capital have screened the FTSE 350 index, ranking stocks by yield, gearing and price to earnings, while considering the underlying free cash flow yield and dividend cover to show whether the current payout is sensible/viable.

From that screen, we have identified several examples which offer a good combination of high income, liquidity and inexpensive valuation.

Among this dozen stocks are several financial firms, two tobacco firms, a mobile network operator, a mining firm, a recruiter, a housebuilder and a real estate investment trust.

All yield 7.5% or more, most have double-digit free cash flow yields, single-digit price-to-earnings ratios and low gearing, and all but two pay a fully covered dividend.

If we left out financial stocks, our list of 12 names would include another housebuilder, another miner, another property fund, a broadcaster and a home retailer, all with fully-covered dividends and a lowest yield of 6.5% which is still respectable compared with the index or indeed with the current 10-year gilt yield.

IS IT BYE, BYE TO BUYBACKS?

An added attraction of ordinary dividend income right now is it is relatively reliable, while capital gains, special dividends and even share buybacks look more vulnerable if interest rates keep rising.

In the first quarter of 2023, global dividend payments increased by 12% according to the Janus Henderson Global Dividend Index, but three quarters of this increase was due to one-off special dividends, currency movements and other factors, meaning underlying dividend growth was just 3%.

Last year, companies paid out $1.39 trillion in dividends globally, but as the Janus Henderson report highlights, they also spent a record $1.31 trillion on share buybacks.

In fact, buybacks have tripled in value over the last decade as companies have found themselves awash with cash earning little to no interest and without any incentive to invest in their businesses.

Buybacks were most prevalent in the US and among financial firms, but in Europe the UK was by far the biggest contributor to last year’s total with $70 billion returned through share repurchases compared with just $29 billion in France and $20 billion in Germany.

Yet higher interest rates mean UK companies need to think again about paying out their surplus cash.

‘Buybacks are seen as a “no strings attached” way for companies to return excess capital to shareholders,’ say the Shore Capital team.

‘But there is no commitment or expectation for buybacks to grow or even continue year after year if management find a more productive use for the capital.

‘Contrast this to dividend payments where progressive dividend policies require year-on-year dividend per share growth. We think structurally higher interest rates may act to reduce buybacks as the interest earned on excess capital is starting to become significant.

‘The corollary of this, in our view, is that demand should increase for stocks offering high dividend yields, with sustainable and growing dividend streams.’

DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. The author (Ian Conway) and article editor (Tom Sieber), own shares in AJ Bell. The author also owns shares in British American Tobacco referenced in the graphic.

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