The outlook for the UK high income sector

The UK high income sector has done well over the past three years. Its constituents' average share price total returns have been better than those of the UK growth & income sector, and their average yield is around a third higher at just over 6%.

However, there are two caveats. One is that the five trusts and three offshore funds that make up the sector have widely divergent remits, records, and ratings.

The other is that none has achieved worthwhile dividend growth over the past three years, several have had to slash their payouts, and others are warning of potential cuts.

Fixed income securities

City Merchants High Yield Trust and New City High Yield Fund both specialise in fixed income securities, so have enjoyed relatively benign conditions thanks to falling interest rates and tightening yield spreads. This has helped them to achieve the best three-year returns in the sector.

But conditions will be harder as interest rates firm up, which may undermine their premium ratings.

City Merchants

City Merchants has been managed since March 2003 by Invesco Perpetual's Paul Read and Paul Causer, who have been very successful over the years in identifying higher-yielding bonds worthy of upward rerating. They were surprisingly badly caught out by the collapse in financial sector bonds in 2008, but held their nerve and were rewarded with a strong recovery in 2009. 

The managers believe there are still attractive opportunities to be found among high-yielding issues. However the trust's income is contracting, and it is running out of past losses to offset against tax, so this year's total payout will be down to 11p and next year's is likely to be lower still.

New City

New City High Yield avoided the worst of the setback in 2008 so has had a smoother run. It seems to be under less pressure on the income front, and has been edging up its dividend - which is paid gross.

But investors should note that Richard Lockwood, who has been lead manager since its 2004 launch, and previously worked wonders for City Merchants, recently handed over to the less proven Ian Francis.

Smaller company specialists

Shires Smaller Companies, Small Companies Dividend Trust and the offshore Acorn Income Fund are all highly geared smaller company specialists. Shires and Smaller Companies suffered severely in the 2007/08 bear market, but have bounced back over the past 18 months.

Acorn has recovered even better, but is comparatively low yielding. Small Companies Dividend performed exceptionally well in 2002 to 2007 and offers an attractive yield despite last year's dividend cut.

This article was originally published in Money Observer - Moneywise's sister publication - in December 2010.

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