Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

The UK has built a reputation as one of the most reliable markets for regular income seekers. As we saw last week, our home market is well exposed to “value” companies which prefer to distribute excess earnings as dividends, rather than reinvesting them to grow their business.

But what had once made this a dividend haven has proved a hinderance since the pandemic struck. Value companies were hit particularly hard by last year’s volatility. As they hurtled headfirst into uncharted waters, many chose to shore up balance sheets instead of portioning out capital to shareholders. What followed was a ‘dividend bonfire’, in which many of the UK’s biggest and most reliable dividend payers cut or cancelled their payments.

Link Group claims that, since April, two thirds of UK companies cut or cancelled their dividends, resulting in a 38% drop in dividends over the whole of 2020.

The good news is that we appear to be through the worst of it. Many companies resumed their dividend payments through the latter stages of 2020. Link now predicts an 8.1% increase in payments over 2021 on a best-case scenario.

The bad news is that we’re still way off where we were. Link’s worst-case scenario isn’t so rosy - the group believes that while dividends could rise, they could also fall 0.6% this year. They don’t expect dividends to get back to their previous highs until 2025 at the very earliest.

We may be through the worst of it, but this is still a difficult landscape to navigate for income seekers.

Here’s how you can keep your cool through the dividend bonfire.

Should you trust yields?

Many income investors look to a company’s dividend yield as a marker for a good investment. The higher the yield, the better the return, right?

Yes and no. A good yield may be tempting, but it can also tell another story, especially in times of volatility.

A dividend yield is calculated by dividing the annual dividend payment by the share price. That means the yield is affected both by increases in the dividend and changes in the stock value. If a company’s stock price suddenly plunges (as many did just before cutting their dividends), its yield will increase. In this instance, a high yield doesn’t look so enticing.

For dividend investors, then, the key lies in knowing whether a good yield represents an opportunity or a warning sign.

One way we can gauge that is is by looking at its coverage ratio. This compares underlying income to dividends paid. The higher the income relative to its dividend, the better protected the dividend. This will vary from sector to sector, but generally speaking a cover ratio below 1.5 would raise eyebrows. It’s always best to compare companies within the same sector to get the best sense of their dividend cover.

Signs of life?

To complicate things further, the dividend bonfire burned more fiercely for some than others. The financial sector was by far the hardest hit, accounting for two fifths of the cuts between April and December, in part because regulators instructed many banks to prioritise their balance sheets at the expense of their dividends.

Oil companies also felt the heat, accounting for £8 billion worth of cuts between them. BP and Shell, the latter of which cut its dividend for the first time since World War Two, are unlikely to get back to their former highs any time soon.

But just as 2020 charred some more than others, prospects vary for different industries heading into this new year.

Banks should have a better time of 2021, with some of the regulations against their dividend payments recently relaxed. Financial companies could also do well in the event of a market bounceback, as we saw last week.

Helpfully, classic defensive stocks remain a good source of reliable income. Unilever, whose brands include Persil and PG Tips, proved itself virtually recession-proof last year. And while offering an attractive yield, it also reinvests capital to build for long-term growth, meaning its prospects look good for the future as well.

Income funds

If you’d rather avoid choosing individual companies, our Select 50 list of favourite investments features a couple of funds which do the hard work for you.

The Franklin UK Equity Income Fund is managed by Colin Morton, with the help of a close-knit team based in Leeds. Morton’s focus is on companies where the dividend is not just high compared to the market, but sustainable and likely to grow. His team is keen to understand the underlying operations of a business, which they feel is crucial in assessing its ability to pay an income.

Familiar names such as Unilever, Shell, and AstraZeneca occupy top spots in the portfolio.

An alternative choice is the FP Foresight UK Infrastructure Fund, one of Tom Stevenson’s fund picks for 2021. Though not focused on equities, it could make a good option for those looking to diversify their income streams as uncertainty abounds.

Managers Nick Scullion, Mark Brennan and Carly Magee target a 5% annual income through an active portfolio of UK listed renewable energy and infrastructure investment companies, though this is not guaranteed.

As well as serving as a diversifier, the managers believe infrastructure is an ideal asset for reliable income sources. UK renewable energy and infrastructure is characterised by high barriers to entry and long term contracted revenue streams, and so typically make for steady income producers.

The fund also has a keen ESG focus, offering investors the chance to support projects that provide essential services to communities and which are building for the transition to a greener economy.

You can read more about Tom’s picks here.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics covered:

UK; Funds; Investing for income

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