Jeff Salway: Challenging times ahead for investors

The darkening of the UK economic outlook poses a challenge for investors looking for reliable sources of income. Picture: Getty Images/iStockphoto

Investors may have to search harder for the income they crave as the downbeat economic outlook threatens to squeeze dividends.

The coming months could be challenging for those in need of a regular income, with the post-EU referendum climate expected to hit the profits of UK-focused companies and undermine their ability to maintain payouts.

Investors and pension savers initially received a boost from the EU referendum result, as the subsequent plunge in sterling increased the value of the dividends declared in other currencies, most notably US dollars and euros. That will amount to a £2.8 billion windfall over the next few months, according to Capita Asset Services, which said the sterling weakness ahead of the vote had already increased the value of payments from the UK’s largest companies.

But the darkening of the UK economic outlook in the wake of the EU referendum poses a challenge for investors looking for reliable sources of income.

While UK dividend payouts reached a record high in the three months to the end of June, said Capita, the figure was distorted by the number of companies paying out ‘special dividend’ windfalls.

The picture is less rosy when those payments are removed, with underlying dividend payments actually falling over that period. Several big names reduced their dividend payments, including Barclays, Standard Chartered, Anglo American and Glencore.

Others are likely to follow. Lloyds Banking Group, which paid a dividend last year for the first time since the financial crisis, this week increased its interim dividend payment. But the state-backed bank warned that “capital generation may be somewhat lower in future years than previously guided”, as statement taken by experts as indicating that future dividends are under threat. The worry now for investors, who can expect the Bank of England to lower interest rates to 0.25 per cent in August, is that an economic slowdown will make it even harder for companies to maintain their dividends.

Dividend cover - the ratio of profits to dividends - has fallen to “very low levels”, the Capita report warned.

“In an ideal world, investors would see dividend cover recover owing to a bounceback in profits, rather than from cuts in the dividend,” said Helal Miah, research investment analyst at The Share Centre.

“With the outcome of the EU referendum likely to hit profits of companies dependent on the UK economy, investors should expect cover to fall further or brace themselves for dividends to be cut; they should be cautious around companies that have a combination of a high yield and a low cover.”

Collective funds rather than individual shares remain the best bet for investors needing a regular income, not least because they provide more diversification. UK equity income funds are particularly popular among older investors wanting both capital and growth (not least because reinvested dividends are one of the biggest drivers of long-term investment growth).

But those wanting reassurance that income payments will continue regardless of the prevailing economic environment should also look at investment trusts.

“I consider investment trusts a superior option against most other sectors, especially for those seeking to maintain a reasonable dividend payout,” said Tom Munro, owner of Tom Munro Financial Solutions in Falkirk.

“The well known reason for this is that Investment trusts are not required to distribute all the income generated by their assets every year.”

That’s because they are allowed to hold back up to 15 per cent of earnings annually so they can pay dividends from those reserves during leaner times.

“During the financial crisis of 2008-09 the majority of UK equity income investment trusts were able to either maintain or increase their dividends, as they were able to call upon their reserves,” said Munro. “In contrast, the vast majority of UK equity income open-ended funds cut their dividends.”

Several investment trusts have managed to increase their dividend payments for more than 40 consecutive years, including one - the City of London Trust - that recently became the first to hit the half century mark.

“From the 25 UK equity income trusts listed in the sector, I like three in particular who have a strong dividend payment history - Frostrow Capital, Edinburgh Investment Trust and Chelverton Small Companies yielding 6.6, 3.7 and 5.10 per cent respectively,” said Munro.