Go global for higher yields

The hunt for income has become a post-credit crisis mantra. In part that's because of the rock-bottom interest rates available to savers for the past three years, which, coupled with inflation at 4.8%, have pushed many frustrated income-seekers towards asset classes they would previously have considered too risky.

But it also reflects the new reality of the developed world's low-growth environment, where dividend yield and the considerable power of compounded dividend growth have become a much bigger deal for investors of all kinds.

So let's consider the opportunities and likely risks facing both bond and equity investors in their search for income.

Equity opportunities

The year 2011 saw a marked upturn in dividends, after many companies cut costs and payouts to shareholders in 2009 and 2010. Capita Registrars' latest (third quarter, 2011) dividend monitor showed payouts at their highest level since summer 2008. Around £55 billion was paid out over the first three quarters of 2011 - just short of the total for 2010. Capita forecasts a payout of £67 billion for 2011.

FTSE 100 company dividend distributions increased by 17% over the quarter, and FTSE 250 firm payouts rose by 9%. "Dividends are growing faster than expected," says Charles Cryer, chief executive at Capita Registrars. "They still have some way to go to hit previous highs, but investors will be grateful that at least one asset class is providing solid, inflation-proof income."

But can such rewarding dividend growth be maintained? Darius McDermott, managing director at Chelsea Financial Services, believes it can. He thinks market dividend growth could be around 10% in 2012. He says: "Companies are really looking after their balance sheets and cash flows now - many are sitting on cash, unwilling to spend on mergers or acquisitions in the current climate. This means dividends are more likely to be paid and be more rewarding, as companies want to keep shareholders on their side."

Other commentators are less convinced. Given the backdrop of uncertainty over whether or how the eurozone will resolve its, so far, intractable problems and the Chancellor's recent hefty downward revision of the 2012 growth forecast, from 2.5 to 0.7% growth, dividend growth seems unlikely, says Anna Sofat, managing director of Addidi Wealth Management.

Ultimately, the economic climate and consumer confidence are likely to determine how far companies go to invest, update, acquire and generally prepare for expansion, and how much they sit on their cash and reward shareholder loyalty.

Despite the growth downgrades and general economic gloom, equity income fund managers appear relatively upbeat about the future. Nick McLeod-Clarke, co-manager of the BlackRock UK Income fund, points to the international nature of the UK market. "Around 80% of revenue from the FTSE 100 (UKX) comes from overseas earnings, so the UK's slowing economy is not as significant as the global economy - and that's growing at about 3% in real terms," he says.

However, FTSE 100 dividends are highly concentrated. Just seven constituents represent more than 50% of FTSE 100 dividend income, so they're in every equity income manager's portfolio.

As well as holding high-yielding large caps, the BlackRock fund holds some strongly performing mid-caps with lower yields or no yield, which McLeod-Clarke sees as "the capital growers, the dividend payers of the future".

But he agrees that the economic slowdown means companies are likely to take a more conservative approach to dividend growth in 2012: "I'm expecting mid-single-digit dividend growth," he says.

The multi-cap equity income approach seems to be gaining popularity. MFM Slater Income, a fund run by Mark Slater, was launched in the autumn, with MAM's Acuim UK Multi Cap Income fund, managed by Gervais Williams, following close behind. Although Slater and Williams both see the attractions of the big, secure high-yield blue chips, they are also interested in the potential of mid-cap and smaller companies to grow dividends.

Williams says: "Small companies have traditionally not been encouraged to pay significant dividends, but many are in a position to increase payouts if they feel it is in their interests to keep shareholders on board." Moreover, smaller companies are much less closely followed by analysts and therefore provide better opportunities for stockpickers to add value.

A more global approach to equity income is becoming increasingly viable. McDermott explains: "Global dividends are forecast to grow by 8.5% next year, but recent research by Investec showed that only five UK companies made it into a global top 100 list based on yield. So one of the strongest reasons to go global in your search for yield is that global fund managers have a wider choice of stocks available to them."

"We've been moving away from Europe and towards Asian and emerging markets where, if you pick and choose, there are very attractive yields and expectations of good growth," comments Stephen Thornber, manager of the Threadneedle Global Equity Income fund, which yields 6%. "Asian companies in particular have really embraced the concept of dividends, I think partly as a means of boosting investor confidence in their corporate governance."

Thornber won't hold any stock yielding less than 4%: he aims for earnings and dividend growth of more than 5% from his holdings. "If you look hard, there are lots of opportunities," he observes.

Fixed interest

"In this low-growth, low-interest rate environment, the search for high income with low risk will be a defining theme of the next decade," comments Jim Cielinski, Threadneedle's head of fixed income. Until now, that role has been filled by core government bonds. But since April 2011, yields on mainstream countries' sovereign bonds have fallen to their lowest levels for decades as investors have sought shelter from the eurozone storm.

But how safe are they?

Government bond yields are now yielding at below inflation levels in the US, the UK and Germany, leaving investors facing negative real returns. Cielinski says: "Those who classify core government bonds as low-risk investments in this environment are guilty of mistaking low volatility for low risk."

And that risk will strengthen if quantitative easing works and fuels inflation. The trouble, according to Stewart Cowley, head of fixed interest at Old Mutual, is that "we're no longer in control of inflation", because it's caused by rising import prices - which are unlikely to fall soon - and a weak pound. "I wouldn't bother with gilts," he says. Even index-linked gilts now look expensive and are delivering real yields of close to zero or even negative yields in some instances.

A downgraded economic growth forecast might in normal, cyclical markets have prompted investors to turn to gilts instead of riskier assets, pushing yields lower. But the UK economy is far from a safe haven at present.

Gilt yields remain low, but it's the eurozone's woes that are pushing "safe haven" flows of cash to the UK. "In the current climate, we also have to factor in inflationary fears and the risk of growing government deficits," says Sofat.

There are better opportunities further up the traditional risk ladder. "Investment-grade bonds and high-yield bonds are pricing in a recession; the high-yield end looks more attractive, but it will be more volatile," comments Adrian Lowcock, senior investment analyst at Bestinvest.

Cielinski likes high-yield bonds and emerging market corporate bonds. Both, he says, "arguably offer greater transparency and a better risk/reward trade-off than government bonds" and will therefore continue to be well supported.

Despite the current economic uncertainty, opportunities for income-seekers do exist. They may, however, need to revisit their ideas about investment risk and reward in a lower-growth global economy.

Emerging market debt: Local currency or dollar denominated?

There is a clear argument in favour of emerging market debt (EMD) over that of developed markets at present. The economic fundamentals are more attractive and real yields are positive.

But should investors opt for funds holding bonds denominated in US dollars or in the local currency?

The first EMD issues were dollar-dominated to appeal to overseas investors anxious about risky currencies. Darius McDermott believes that, in the short term, there's likely to be less currency risk volatility with bonds denominated in US dollars.

Adrian Lowcock agrees. He observes that the dollar is relatively closely correlated with the fortunes of sterling: "Both countries have weak growth outlooks and historically low interest rates, so dollar-denominated bond exposure will take out much of the currency risk."

But that won't last indefinitely. He adds: "We expect the US dollar to be in long-term decline against emerging market currencies, so it's preferable to have some local currency exposure as well."

Indeed, as emerging economies and their currencies have strengthened, governments have bought back US dollar-denominated bonds and reissued local currency debt to meet demand.

"The shorter supply of US dollar debt means it's often more expensive," says Anna Sofat. Also local currency debt tends to pay a higher yield to compensate for the higher currency risk involved. And because local currency emerging market bonds provide exposure to emerging market currencies, as well as delivering income, investors "are effectively adding diversification to their portfolios", Sofat adds.

However, EMD should be approached with caution. It is a more volatile area than traditional bond funds and is likely to be harder hit if investors become risk averse.