How to sniff out dividends

Although the start of 2010 has seen much newspaper coverage devoted to disentangling the conflicting signals from the global economy, little consensus has emerged.

Inflation might happen, but deflation is still a possibility. Sterling could devalue or rise depending on the economist. Interest rates could stay low for five years or rise within months.

However, the one thing everyone agrees on is that taxes are going to rise, so generating a tax-free income stream will be even more valuable. The case for investing in ISAs is clear; the underlying investment strategy less so.

ISAs remain the simplest means to create a tax-free income.

The tax reliefs on ISAs stack up well against pensions for those earning more than £150,000, as they may get as little as 20% tax relief on pension contributions and may be subject to 40% or even 50% on the income at maturity.


Even for those not in this position, ISAs offer a flexible way to generate income in a tax-efficient way.

The ISA wrapper is only one part of the equation, and choosing the right underlying investments to generate a high and sustainable income is no mean feat in the current environment.

The tax treatment of different asset classes will vary within an ISA wrapper. In all cases, there is no tax liability on the income paid out.

However, investors can claim a 20% tax credit for tax deducted at source on interest payments, which includes income from cash, gilts and corporate bonds.

For payouts from shares - dividends - no tax can be reclaimed for the 10% tax liability paid by the companies themselves. Interest-generating investments therefore have a small tax advantage over dividend-generating investments.

There are a number of other considerations though. More than ever, the past two years are an unhelpful guide to the likely performance of different asset classes over the next few years.

Prices of shares and bonds have been driven by, in 2008, excessive fear, and in 2009, excessive optimism. Neither is a helpful predictor for investors, so they have to pick their investments while negotiating an unprecedented diversity of views from the experts.

Cash disappoints

Cash ISAs would usually be a first port of call for income seekers, but with interest rates at all-time lows, returns look anaemic.

The top rates tend to be offered by the smaller building societies, many of whom are trying to build up their deposit bases to support their mortgage businesses.

The top rates over one year are just over 3% and for some, this includes a 1% bonus for 12 months.

The last set of inflation figures showed consumer prices rose at an annual rate of 2.9% to December. Therefore, many cash ISAs are eroding capital in real terms.

Gavin Haynes, investment director at financial adviser Whitechurch Securities, says: "Cash offers very little.

"With increases in tax and cuts in public spending in the offing, interest rates can't be increased without crippling the economy, so we believe cash will continue to produce disappointing returns."

If the thought of moving out of cash is too terrifying given the unpredictability of the economic climate, tying up money for longer will provide a higher rate.

Savers need to bear in mind that interest rates may move up next year, but David Black, banking specialist at financial analysis group Defaqto, points out that while rates may look low at the moment ISA allowances work on a "use it or lose it" basis.

Government bonds have also been a preferred choice for the income-seeking, risk-averse investor. Ten-year gilts are currently generating an income of 3.5% to 4%; low by historic standards.

In the UK and other indebted developed markets, there remains a risk to capital over the shorter term.

The gilt market has been supported over the past year by government intervention via quantitative easing.

This £200 billion artificial prop has now been removed and there is a real question over who will become the main buyer of gilts after the Bank of England. With a lack of buyers, prices will fall.

Bonds in a bind?

Peter Geike-Cobb, manager of the Thames River Global Bond fund, says: "The biggest risk is that the UK deficit is not addressed. The rating agencies are providing some breathing space until the government comes up with a plausible solution, but it remains a risk."

He doesn't believe gilts will go into freefall, but has looked to shore up his portfolio with exposure to the government bonds of Germany and the US, which have a better outlook.

Haynes suggests an alternative approach to investment in government bonds: "Emerging markets debt funds are starting to be more of an established asset class. Threadneedle and Investec have funds with a good track record.

Emerging markets governments often don't have the debt burden of Western governments and it is certainly worth having some exposure to generate additional income."

These funds will pay considerably higher than developed market government bond funds. For example, the Investec Emerging Markets Debt Fund currently has a distribution yield of 7.44%.

The corporate bond sector has had a barnstorming year and is often the natural choice for income seekers. The average fund in the UK corporate bond sector rose by 15% in 2009.

The sterling high yield sector (bonds for higher risk companies) beat most equities markets last year, delivering an average return of 48%. Although this came from historic lows, there are suggestions that corporate bonds may have had their moment in the sun.

Darius McDermott, manager director of Chelsea Financial Services, says: "We are likely to be moving to a more normal environment for bonds, where investors collect the coupons for yield and get a bit of capital return.

A good fund manager will be watching for defaults and could return 6% to 12%."

John Hamilton, manager of the Jupiter Corporate Bond fund, agrees that managers need to be selective: "We don't think there is a lot of value in high yield given the default rates and are focusing our attention on the better end of the corporate bond market, such as telecoms or utilities."

He thinks that if the economy weakens as quantitative easing is removed, investors might move away from higher-risk assets.

Nicola Marinelli, fund manager at fixed income specialist Glendarvon King, says: "Corporate bonds had a bumper year in 2009 and that rarely happens. It is natural to question how well they can do this year.

There are some scenarios in which bonds could trade down quite dramatically this year, so we are staying in larger bonds with good risk ratings and liquidity."

The yield on corporate bond funds ranges from 6.8% at the top, down to 1.85% at the bottom, with most funds yielding between 4% and 6%.

One option for investors still keen to invest in bonds is the strategic bond sector. Gary Potter, joint head of multi-manager at Thames River Capital, prefers this type of fund to more conventional corporate bond funds at this stage in the market cycle.

Managers have a free rein to move into different types of bond as they deem appropriate. This gives them far greater flexibility to generate income and capital growth and can work better in an uncertain environment. Potter favours the Henderson Strategic Bond fund.

Equity income

The equity income sector has had a torrid couple of years.

Knocked first by the well-documented troubles in high-yielding financials and then by the market's insatiable appetite for riskier stocks, the sector is around 7% behind the UK All Companies sector over one year and 5% behind over three years.

Companies have also cut dividends savagely: dividends on the FTSE All-Share index fell around 15% last year.

Potter is predicting a better year in 2010 and believes, unusually, that there may be more risk in corporate bonds than in equity income this year. In exceptional cases, he says, the dividend paid by companies is higher than the yield on the same company's corporate bond.

He believes that the defensive high-yielding shares that characterise equity income funds will bounce back this year after a weak 2009.

Karen Robertson, manager of the Standard Life UK Equity High Income fund, says the headwind of companies' dividend cuts will disappear: "In general, they were worried about their ability to refinance.

Companies can now get finance and dividend cover is at historically high levels. There is no reason to see more dividend cuts."

Tony Nutt, manager of the Jupiter Income trust, says there may even be dividend growth in 2010. He adds: "Investors tend to move into equities as dividend growth builds.

Some equities are not particularly cheap - mining and property are likely to have a tougher 2010, but parts of the market such as pharmaceuticals and telecoms have been left behind in this year's rally and should do well. This favours equity income managers."

The yield on the FTSE All-Share is 2.7%, but equity income funds are generally paying more, with the majority of funds yielding between 4.5% and 6%. All equity income funds offer some protection against inflation, unlike fixed income assets.

However, the sector must still face down criticisms that funds are increasingly "clustered" in a few stocks and sectors. After dividend cuts in 2009, fewer stocks offer the payouts that equity income managers rely on.

Managers have tackled this in two ways: either they have looked globally or they have moved down the market capitalisation scale.

Funds such as the Henderson UK Equity Income trust will invest in small and mid cap names to diversify the yield. The Standard Life UK Equity High Income fund has shored up performance by taking a barbell approach.

Part of the portfolio is invested in non- or low-yielding stocks to improve returns in markets that favour small and mid caps.

Another development has been the popularity of global equity income funds.

Previously, companies in emerging markets have tended not to pay a significant yield, but as companies have grown more attuned to the demands of international investors they have increasingly prioritised cash payouts for shareholders.

Haynes believes this is a good way for investors to create a diversified income stream. There are still relatively few funds in this area, but Aberdeen, Schroder, Henderson and Newton have Asian income funds.

Aberdeen, Newton, Templeton, M&G and AXA Framlington have global income funds.

Which managers do the experts favour? Potter says: "We support Clive Beagles at JO Hambro, who has had an excellent year and could continue to do well. Neil Woodford at Invesco has had a terrible year because he has been so cautious, but may well come right again this year.

We want funds to do different jobs, so we tend to blend steady-eddy funds such as the Neptune Income fund, with the Schroder Income Maximiser that uses derivatives to boost yield."


The one remaining area for income seekers is property. This has become a pariah investment for many after liquidity problems in 2007 and 2008 saw some funds close to redemptions, but the sector may be turning.

The benchmark Investment Property Databank UK Monthly index finally turned positive year-on-year in December after five straight months of gains.

Which asset is most appropriate for you will depend on your existing portfolio and risk tolerance. Last year's strong gains have left some assets with little upside, but there is still money to be made. Ultimately, however, sheltering income from the tax-man is the easiest gain for investors.

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

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