On 1 August the Bank of England’s Monetary Policy Committee made a 5-4 decision to kickstart its rate-cutting cycle. A 25 basis point reduction in the base rate to 5% marking The Old Lady of Threadneedle Street’s first cut since March 2020.

This means cash savings rates are heading in one direction, down. And the lower-than-expected jump in UK inflation reported on 14 August only boosted market expectations that the Bank of England could deliver another rate cut next month.

As the rate environment turns, those who want to grow the income their money generates will need to shift out of cash and money market funds and into the financial markets and, in particular, stocks and shares which offer the potential for both yield and capital appreciation.

Dividend paying shares offer a generous income today, but with the added kicker of potential growth in that income stream into the future, and myriad London-listed stocks are currently yielding more than the 5% base rate and the 3.5%, 3.8% and 4.4% returns respectively from the two-year, 10-year and 30-year UK gilts. A word of caution though – dividends are not guaranteed.

In this article we will highlight the income stocks favoured by fund managers, equity income investment trusts and vehicles which hold other income-bearing investments like property, bonds and infrastructure.

THE PITFALLS OF HIGH YIELDS

The risk of chasing higher-yielding shares is dividends are not set in stone and can be cut or even cancelled all together. Often a high yield signals that a company’s dividend is looking vulnerable and investors have marked the shares lower in anticipation of a reduction or suspension of the payout.

David Smith, fund manager, Henderson High Income Trust (HHI), says equity income should be a key consideration for income-seeking investors given dividends are linked to company profits, thereby giving the potential for dividend growth and protecting an investors’ income against inflation.

‘However, caution is needed when selecting a company that pays a high dividend yield as this can be misleading if the dividend is unsustainable, leading to a dividend cut and a fall in the share price,’ Smith warns. ‘Investors need to make sure a company’s dividend is repeatable and can grow into the longer term, key elements to a shareholder’s total return. Understanding a company’s financial health in terms of sustainability of profits, balance sheet robustness, well invested asset base and strength of cash flows provides valuable insights into its ability to pay and grow its dividend.’

Andy Marsh, co-manager of the Artemis Income Fund (B2PLJH1), warns the investor’s quest to attain income must not be focused on scrolling through companies online and looking at the yield numbers. ‘For a start, these may be inaccurate. Are they historical yields or based on forecast earnings? And where will the yield be in three years? The same, lower, higher or non-existent? Start with cash flow. This is profit available after everyone has been paid,’ says Marsh. ‘You want a successful business generating strong cash flow that can grow – this is what pays your yield. Finding these strong businesses requires you to scour the financial results of businesses, and, in particular, cash flow statements. This focus helps you cut out those companies paying unsustainably high dividends that are sometimes a function of their share price going in the wrong direction – the falling knives.’

Iain Pyle manages Shires Income (SHRS), an investment trust that seeks to provide a high level of income, together with the potential for growth of both income and capital, by investing in UK equities, preference shares, convertibles and other fixed income securities. Pyle thinks UK equity income is in an interesting place right now, having been out of favour in recent years. The market has been very focused on mega-cap growth, while high cash returns have made equity income less necessary or attractive for many investors when they can earn 5% on their savings accounts.

‘Both of those drivers are facing headwinds right now,’ says Pyle. ‘Concentration in tech is very high and stocks highly rated, increasing the risk of disappointment. For cash, interest rates have started to come down, so investors are seeing falling returns on cash and also realising that it does not protect them from inflation as well as equities do. With a 6% yield on the shares today, Shires now offers materially higher income than cash combined with the potential for capital growth and a track record of dividend growth over time.’

Simon Gergel manages The Merchants Trust (MRCH), which seeks to provide an above average level of income, income growth and long-term capital growth by investing in higher yielding UK large caps. Trading on a 4.9% dividend yield, Merchants has notched up a formidable 42 years of unbroken dividend growth and Gergel is excited about UK equities for a variety of reasons. ‘We’re seeing buybacks from companies and a huge number of takeovers, so there are buyers coming into the market, and valuations are much cheaper than their own history and many other markets. Interest rates coming down makes the alternative sources of return more difficult, whether that’s cash or bonds,’ says Gergel. ‘That should be very helpful for higher yielding shares. There is some evidence that higher yielding shares have done better than the average company over the very long term.’

EQUITY-BASED INVESTMENT TRUSTS FOR INCOME

Thanks to their structure, which allows them to hold back income during good years to help sustain payments in more fallow periods, investment trusts often have enviable track records of dividend growth going back years or even decades.

Because they are invested in a diversified portfolio of dividend-paying shares they also reduce the risks of an individual company cutting or cancelling its dividend.

The yields available from trusts in the AIC (Association of Investment Companies) Global Equity Income sector are appreciably lower than those from the UK Equity Income category.

This reflects the relatively depressed valuations in the UK market, particularly compared with the US, and a stronger dividend-paying tradition and higher payout ratios (i.e. the proportion of a company’s earnings paid out in dividends) than in other geographies.

Looking at the list we have included everything with an historic dividend yield of 4.5% or more and have only included trusts which have delivered growth in their dividend over the last five years.

This does exclude on of the trusts with the best five-year dividend growth (of more than 11%) in Law Debenture (LWDB). While the starting yield is a relatively modest 3.7% the company benefits from a unique combination of a traditional investment trust holding income stocks alongside a cash-generative professional services operating business.

Of the names in the table Chelverton UK Dividend (SDV) has the highest yield at 7.5%. Two points to note. It invests in UK small caps – which can be more prone to cutting or cancelling dividends. It also has very high ongoing charges – 2.44% according to the AIC.

We would instead highlight another two names which we believe are worth buying for the income they offer today and income growth potential. The first is Dunedin Income Growth (DIG). This trust focuses on quality companies which meet its sustainability criteria as well as offering ‘real’ income growth over the long term. They are focusing on names which can sustain dividends, even during tougher times. The portfolio includes UK-listed names like consumer goods giant Unilever (ULVR), electricity network operator National Grid (NG.) supplemented by a couple of overseas selections in Novo Nordisk (NOVO-B:CPH) and ASML (ASML:AMS). The trust trades at a discount to NAV (net asset value) of 11%, has ongoing charges of 0.64% and yields 4.9%.

The other name we like is JPMorgan Claverhouse (JCH), where a balanced approach, mixing growth and value, has helped deliver a measure of consistency in returns and where the company has pledged increase dividends at a rate close to or above inflation. Steered by William Meadon and Callum Abbot, Kepler notes the trust has outperformed in two thirds of the quarterly periods since the former took over management of the trust in 2012. Like Dunedin there is a focus on quality as well as high yields, with top holdings including the likes of Shell (SHEL) and private equity outfit 3i Group (III). Ongoing charges are 0.7% and the historic yield is 4.8%. [TS]

FUND MANAGERS’ STOCK PICKS FOR INCOME

When picking stocks, Shires’ Pyle always looks for a combination of dividend yield and dividend growth, ‘so a company with a 5%-plus yield and good growth outlook is exactly what we are after and there are a few in the portfolio’, he enthuses, highlighting BP (BP.) and NatWest (NWG), which both have ‘yields over 5% and the potential to grow dividends in the next few years. The thing that connects them is the power of a substantial buyback program, meaning that share-counts are falling rapidly allowing for dividend per share to increase more than 5% per year even if absolute distributions stay flat.’

Gergel likes healthcare property play Assura (AGR), which has an 8% dividend yield underpinned by asset value and a good record of growing dividends over many years. ‘Most of its properties have rising rents either with inflation, which is either guaranteed or else over time there is a mechanism to reflect higher building costs in the rents Assura can charge GPs,’ explains Gergel.

Henderson High Income’s Smith is a fan of 5%-plus yielder Dunelm (DNLM), the homewares retailer with ‘a strong business model which supports its competitive price position that has driven market share gains and profit growth. The company also has a robust balance sheet and high free cash flow which supports an attractive and growing ordinary dividend yield which is supplemented by repeatable special dividends.’

Seasoned investor James Henderson, co-manager of investment trusts Lowland (LWI), Law Debenture and Henderson Opportunities Trust (HOT), highlights the attractions of insurance company Sabre (SBRE), which currently yields a base-rate and inflation-beating 7%.

‘Sabre is a very disciplined underwriter of non-standard motor insurance,’ says Henderson. ‘It’s the place you go to if you are having a mid-life crisis and have just bought yourself a 750cc motorbike when you’ve never ridden anything more than 100cc before. By really understanding the customer, Sabre can deliver bespoke cover. ‘Most motor underwriters make very little on each transaction. The figure you need is the ‘combined ratio’, a measure of costs, including expenses and claim losses, divided by earned premia. For many underwriters that ratio is 100%, which means they are neither making nor losing money beyond the interest they get on holding the premium cash. But Sabre has a ratio of 85%, so it’s doing well. Motor insurance has a reputation as a difficult industry for investors but Sabre has a good management team and is well run.’

Artemis’ Marsh highlights the 6.5% yield on offer from free-to-air broadcaster ITV (ITV). ‘That is high and would normally make me somewhat wary,’ says Marsh. However, ‘it looks increasingly secure but additionally the business is benefiting from investments in technology and cost savings. So, the dividend has some protection if advertising revenue, which is cyclical, declines materially. The investment in ITVX is generating a different sort of ad revenue - more akin to online advertising. It is premature to suggest that ITV can materially grow its revenue and earnings from advertising but the current buyback is already making more dividend money available for remaining shareholders, even if the business stands still.’

A WEALTH MANAGER TO WATCH

Brendan Gulston, manager of WS Gresham House UK Multi Cap Income (BYXVGS7), points out that the UK wealth management sector has been out of favour as interest rate increases have moderated net flows, with households prioritising or re-allocating personal cash flows to areas of higher need. But with interest rates falling and inflationary pressures abating, the backdrop for businesses with strong operational leverage is improving.

One example is vertically integrated wealth management business Quilter (QLT). ‘There is significant operational leverage within the business which drives attractive potential profit scalability as the market backdrop improves,’ observes Gulston: ‘We.invested at a circa 10 ex-cash price to earnings multiple when the stock was paying in excess of a 5% yield. Whilst recent share price performance has been strong and the dividend yield has moderated slightly to circa 4%, we think there is considerable further upside as the company delivers on its strategy.’

BOND FUNDS ARE AN IDEAL WAY TO ADD SECURE INCOME

As we explained in our education piece on building a portfolio, bonds should be a part of every investor’s tool-kit.

For absolute beginners, a bond ETF (exchange-traded fund) is probably a good call, but for those looking for a high but reliable stream of income then a fund or an investment trust would be a better solution.

While the returns on bonds are obviously linked to interest rates, there are a few trusts in the AIC’s (Association of Investment Companies) ‘debt’ sector which still offer high single-digit yields without taking lots of risk.

TwentyFour Asset Management is a specialist fixed-income manager owned by Swiss group Vontobel with £19 billion of asset under management including one of the most popular bonds funds and our pick in this space, TwentyFour Select Monthly Income (SMIF).

The fund has assets of just over £200 million, yields 8.75% and pays a dividend monthly, which makes it ideal for those looking to pay bills or meet other small monthly outgoings without touching their capital.

It is also ideal for those looking to compound their returns rather than taking a monthly income as the dividends can be reinvested every month rather than every quarter or half-year as with most other trusts, meaning compounding gets to work straight away.

The fund is designed to take advantage of the high returns available on less-liquid debt, which is often overlooked by investors but is well-suited to a closed-end structure, and targets a dividend yield of at least 6% with a net total return target of 8% to 10% per year.

We should point out that less-liquid doesn’t mean lower quality, it can be that the bonds are tightly held by financial institutions and family offices and don’t trade very frequently.

Among the top 10 holdings in the Select Monthly Income Fund are bonds issued by building society Nationwide, NatWest, pension insurance specialist Rothesay Life and Santander UK.

Two more relatively high-yielding bond trusts are CVC Income & Growth (CVCG) and Invesco Bond Income Plus (BIPS).

The £200 million CVC fund, managed by Pieter Staelens, invests mainly in leveraged loans rather than high-yield debt and therefore has exposure to floating-rate securities not just fixed-rate.

The loans are typically secured on an underlying asset so there is a degree of security to them, which isn’t the case with all bonds, many of which are IOUs rather like credit card debt with no asset backing.

The £370 million Invesco trust invests in traditional high-yield bonds but also buys lower-rated subordinated debt issued by European financial institutions and even has a ‘recovery’ segment where it buys the bonds of businesses which are turning themselves around. [IC]

Disclaimer: The author (Ian Conway) owns shares in TwentyFour Select Monthly Income and CVC Income & Growth.

REAL ASSETS CAN CONTINUE TO GENERATE ATTRACTIVE RETURNS AS RATES FALL

Just as bond funds can buy different types of debt to achieve a high yield, infrastructure and real estate trusts can cover a whole range of investments.

Some infrastructure trusts invest directly in actual physical assets, while some invest in the share capital of companies operating in the infrastructure sector and others invest in the debt issued by those companies.

Similarly, UK real estate investment trusts – or REITs, for short – can own all kinds of commercial property from supermarkets to warehouses for ecommerce companies like Amazon.com {AMZN:NASDAQ) to data centres for tech companies focused on AI (artificial intelligence).

The best-yielding infrastructure trusts are Sequoia Economic Infrastructure Income (SEQI) and GCP Infrastructure (GCP), both of which currently trade on an 8.6% yield and both of which invest in the debt of companies involved in power and other utilities, including renewables, as well as transport systems and other critical infrastructure, and use the income they receive to pay dividends.

We would flag Sequoia as the best option. It owns 56 investments, with an average value of just over £20 million and an average maturity of four years, and is tilted towards data centres, telecom infrastructure, electricity and energy efficiency including renewables.

GCP is tilted more towards public infrastructure including schools, hospitals and healthcare centres, and alternative energy such as wind, solar and biomass.

REITs on the other hand invest directly in commercial property, with the aim of paying out their earnings in the form of dividends, so the yield depends on how much the firms are able to increase rents and grow their income.

In the case of AEW UK REIT (AEWU), Supermarket Income REIT (SUPR) and Custodian Property Income REIT (CREI), all three are growing their rental income by 10% as demand for good-quality, well-located assets continues to increase while supply is limited.

Our pick is AEW UK REIT which owns smaller properties, typically with a value of £15 million or less, in the office, retail, industrial and leisure sectors, with a focus on active asset management meaning it looks to improve the quality of its income stream.

Supermarket Income REIT, as its name suggests, invests in retail property and currently has a portfolio of 73 omnichannel stores, which offer in-store shopping but also operate as last-mile and online fulfilment centres, with a value of over £1.7 billion.

Custodian Property Income REIT owns a broad portfolio of properties across the industrial, warehouse, office and retail sectors as well as petrol stations, bowling centres, car dealerships and even drive-through restaurants, making it highly diversified in terms of income.  [IC]

Disclaimer: The author (Ian Conway) owns shares in Sequoia Economic Infrastructure Income and Custodian Property Income REIT.

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