Salvaging investment income when big dividends dry up

WITH low interest rates savaging savings returns, the suspension of BP's 2010 dividend last month was a savage blow for income investors. Yet the income stream can continue flowing for those willing to diversify, with a growing range of investments to explore.

The loss of the BP dividend is significant for income investors - the oil giant accounts for some 12 per cent of total UK dividend income. Investors had already seen UK companies cut their dividends by 15 per cent last year, with shareholders paid 10 billion less in dividends than in 2008.

But Alastair Wilson, fund manager and director at Brooks Macdonald Asset Management in Edinburgh, said many investors are too dependent on a small group of stocks for income.

"Apart from BP it is a source of concern that four other large companies - Shell, HSBC, Vodafone and Glaxo - account for another third of UK total dividend income. Many investors with high income requirements will have a large part of their portfolio in these four stocks."

The reduction in dividends has particularly hit cautious investors forced into equities after the plunge in savings rates since late 2008. But for those comfortable with deriving their income from equities, all is not lost. Here are five ways to give your investment income a boost:

INVESTMENT TRUSTS

A number of investment trusts focus on firms outside the FTSE 100, in contrast to many of the best-known income unit trusts.

Wilson singled out the Montanaro UK Smaller Companies investment trust, which is producing a yield of 2.6 per cent; the F&C Commercial Property, yielding 6.6 per cent; and the Schroders Mid 250 investment trust, with a yield currently of 2.8 per cent.

Elsewhere, the Dunedin Smaller Companies trust run by Edinburgh Fund Managers currently has a dividend yield of 4.25 per cent, derived from a large weighting in UK industrial stocks. Similarly, the Aberforth Smaller Companies trust has a historic dividend yield of 3.65 per cent, although its share price return is down more than 20 per cent over the past three years.

PROPERTY

Commercial property funds lost their lustre with a two-year fall of over 45 per cent from summer 2007, and a recovery that began last summer has regained less than a third of those losses. However, property funds remain a viable income option, echoing the pre-boom days when they were viewed as a diversification and income play.Wilson said: "Obviously there are varying degrees of risk in these areas, but for example, one property trust that yields 6 per cent has almost 700 tenants … you need them all to stop paying their rent to be in a BP situation of no dividend."

About 20 property funds currently yield above 3 per cent and seven above 4 per cent, according to Trustnet. It pays to be selective, however, with several property funds not providing any yield.

GLOBAL FUNDS

Until relatively recently the choice of funds sourcing their dividends from outside the UK - particularly from emerging markets - was meagre.

But that is rapidly changing. The latest global vehicle was launched yesterday in the form of the Artemis Income fund, targeting a yield of 4 per cent a year. The fund is likely to have 30 per cent each invested in US and Europe, about 25 per cent in Asia and Latin America and just 5 per cent in the UK.

Other recent launches include Edinburgh-based Baillie Gifford's global income fund, while Newton runs the global higher income and M&G the global dividend fund, launched two years ago.

Emerging markets have proved less fertile for dividends, but regular dividend income has grown more quickly in Asia than in the West of late. Somerset Capital Management earlier this year launched the emerging markets dividend growth fund, the first for UK investors to focus on income from emerging markets' companies and expected to yield around 4.6 per cent.

Similarly, Schroder recently launched the Asian Income Maximiser fund, aiming for a gross yield of 7 per cent.

VENTURE CAPITAL TRUSTS

VCTs are a higher-risk alternative but can pay a high (and tax-efficient) income for those happy to hold on for five years. Investors receive tax relief at 30 per cent on investments of up to 200,000 each tax year, provided the investment is held for five years, while gains are free of capital gainsc tax.

Tom Munro, director of Tom Munro Financial Solutions, said: "With dividends ranging from 4.2 per cent up to the 7.5 per cent paid by Baronsmead VCT 3 last year, these rates of return offer investors an excellent taxefficient income stream. Higher rate taxpayers would have to uncover a share yielding 10.4 per cent to match the return from a trust paying a 5 per cent dividend per year."

Many VCTs are high risk, but managers including Octopus Investments offer lower risk trusts backed by secured lending, while others have similar offerings backed by property and other low-risk instruments.

HIGH INCOME FUNDS

Income unit trusts tend to source their dividends from the same pool of large blue chips, but holding them alongside some of the options above means there is vital diversification. And there is an expanding universe of higher income funds available that sacrifice capital growth for extra income.The 2.8bn Newton High Income fund is the most obvious example, with a 12-month historic dividend yield of 7.84 per cent, as at the end of June, despite an 8 per cent BP holding.

Other examples include the Invesco Perpetual High Income, the Schroder Maximiser and Fidelity's Enhanced Income. But while they pay income of around 7 per cent, they use derivative strategies too complex for many investors to understand. And the focus on income at the expense of capital growth means they are technically riskier than normal income funds, which can still provide growth when income levels fall.