With UK interest rates having fallen to such lows and lacklustre yields on offer from both government and corporate bonds, it's little wonder that investors searching for income are finding themselves drawn towards equities.
The stock market recovery and strong results from a string of household names has increased the appeal of equity income investing, in which you buy shares in companies that pay dividends or put your faith in an income-seeking fund and let its manager make the decisions.
Three types of people find this sector particularly attractive, according to Patrick Connolly, head of communications at AWD Chase de Vere: those in need of an income now; those expecting to want one in the future; and those looking to reinvest dividends for better longer-term results.
"It has been shown over many years that dividends make up a sizeable proportion of total stock market returns, and that is why many growth investors are keen to invest in shares which produce dividends as these are subsequently reinvested to boost total returns," he explains.
It's easy to understand the appeal. By their very nature, companies that are in a position to pay dividends to shareholders are making positive statements about their future prospects. In uncertain times this isnot only potentially lucrative for the investors, but extremely reassuring.
"Shares which produce consistent dividends have long been favouredby income investors who believe they are investing in very strong and secure companies," adds Mr Connolly. "However, you are taking on high levels of risk if individual shares make up a significant part of your portfolio."
This is because dividends are not guaranteed. Companies can reduce the amounts they pay back to shareholders – or even cut the dividend completely in tough times. We saw this last year with BP in the wake of the Gulf of Mexico disaster.
The outlook for dividends
The global economy has spent much of the last five years in meltdown – particularly the previously reliable income generators such as banks which were badly affected by the financial crisis – so what are the prospects like for dividends now?
According to the UK Dividend Monitor compiled by Capita Registrars, the answer is pretty good. UK dividends totalled £15bn during the first quarter of this year – 10.3 per cent up on the same period in 2010 and comfortably the highest first-quarter total since its analysis began in 2007. It expects total dividends for the whole of 2011 to come in at £64.2bn, which equates to growth of 7.9 per cent.
So how should you invest?
There are two ways to invest for income: via shares or investment funds. According to Justin Modray, founder of the website Candid Money, the choice will depend on a person's investment goals, knowledge of stock markets, spare time to devote to analysis and overall attitude to risk.
"Buying companies is cheaper because you don't have to pay a fund manager, but it can leave you more exposed as funds will invest in many more stocks," he says. "Good fund managers should also be able to add more value to outweigh the fees charged – although that's not always the case."
It can be very tempting to buy companies that have the highest dividend yield – best defined as the dividend that is being paid by a company expressed as a percentage of its share price – especially as a number of companies are yielding in excess of 5 per cent at the moment. However, this can be dangerous for the simple reason that it may not be sustainable. Therefore, you will have to look a little deeper to get a clearer picture of what is on offer, warns Nick Raynor, investment adviser at The Share Centre. "Investors need to ensure the dividend is well covered and that the monies to pay this dividend should come from profit," he explains. "They must also decide if the yield [being offered] is realistic by taking a look at past performance to see if it seems viable."
Companies perceived to be most likely to continue paying dividends are those that are able to generate free cash flow – that is effectively the amount of money it has at its disposal after paying all the various costs associated with its business activities.
Investing in funds
Geoff Penrice, an independent financial adviser with Honister Partners, recommends that investors consider both qualitative and quantitative measures when choosing between funds, pointing out that he prefers those that are capable of delivering consistent returns at lower levels of risk.
"Qualitative measures include the methods and processes which the fund manager employs to research and analyse the market in which they operate, whereas quantitative is looking at the performance and volatility of the fund over different timescales and in different conditions," he says.
He cites the Invesco Perpetual Income fund, which has been run by Neil Woodford for more than 30 years, as an example of the type of well-managed portfolios with good risk-adjusted returns in which he likes to invest his clients' money.
"It will be on most people's lists because of its long-run consistency," he says. "Neil also has a strong enough track record that he does not have to follow short-term fads or fashions; he can focus on long-term objectives."
A glance at the returns generated by funds in the IMA UK Equity Income sector illustrates the importance of choosing carefully. Over the last five years the best funds have delivered around 60 per cent, while the worst have lost almost 20 per cent, according to Morningstar, to 21 July this year.
When selecting equity income funds you should also be aware that many funds end up investing in the same companies. Someone with a portfolio of equity income funds may in effect be taking on extra risk through duplicating their exposure to certain names. Just five companies accounted for more than half – £7.6bn – in dividends paid during the first three months of 2011. AstraZeneca took the top spot, followed by Vodafone, Royal Dutch Shell, International Power and HSBC.
Patrick Connolly suggests that taking a global approach may help to combat this problem. "Investors should look at the growing number of international equity income funds to hold alongside UK funds," he says. "This is a sensible way to maintain a competitive level of income while diversifying risks."
We asked Nick Raynor, investment adviser at The Share Centre, to highlight some stocks he thinks could be suitable for income-seeking investors.
The insurance group has been expanding and developing a position in European markets, where the company has focused on long-term savings. Margins have been improving as the focus has been on higher-value products during the period. General insurance sales in the UK rose 20 per cent to more than £1bn, and since the start of 2010 Aviva has added 580,000 motorists to its insurance book.
The mobile giant's last set of results saw the company beat market expectations, and its 26.4 per cent increase in data sales shows the rise in demand for smartphones. There are continued plans for growth in emerging markets, and this will continue to attract investors seeking international exposure. The world's largest mobile telecommunications company remains our preferred play in the sector that has continuing upward momentum.
Food sales have provided a vital boost to the company coffers.This is a higher-risk recovery stock, with an attractive yield, which has been swimming against the tide of economic and sectorconcerns.
We asked Patrick Connolly, head of communications at AWD Chase de Vere to pick three funds that would appeal to income-seeking investors and outline what he likes about them.
Newton Global Higher Income
This is an international fund investing in the US, Europe, Asia and emerging markets, as well as the UK, and so provides good diversification when held alongside UK equity income funds. Newton's investment approach is team-based value investing and they are recognised by many as a leader in this field. They provide a consistent safe pair of hands for investors.
Schroder Income Maximiser
This fund holds virtually thesame underlying shares as theSchroder Income fund, but gives up some of the growth in these shares to generate a higher level of income,making it ideal for those where income is the main concern. It targets an income of 7 per cent each year and has exceeded this to date.
This fund has been managed byRobin Geffen for the past eight yearsbut is run very much on a team basis.It is a traditional equity income fund which invests in 33 equally weighted shares. It focuses on total returnrather than maximising income andhas a consistent performancerecord.