Don't ignore UK dividend stocks and these great income funds
UK equity income investors are enjoying a stellar year. According to Capita's third-quarter dividend report, UK companies are on track to pay out £94 billion to shareholders by the end of December, smashing the previous record of £88 billion set in 2014 and delivering year-on-year growth of 11%.
Total returns haven't been bad either: the average fund in the Investment Association (IA) UK equity income sector returned 12.4% in the year to 31 October.
However, as storm clouds - not least in the shape of an end to the hefty uplift provided by the weak pound - mass on the horizon, some investors are growing concerned over the durability of the legs on this equity income bull run.
The strong year enjoyed by UK dividends is down to two main factors. The first is significant pound weakness since the UK's referendum on EU membership in June 2016.
More than a third of companies in the FTSE 100 (UKX) pay their dividends in US dollars, so a tasty exchange rate gain is delivered when the pound's value is down against the dollar.
Since the UK voted to leave the EU, sterling has fallen more than 11% against the dollar - from a pre-vote high of £1 = $1.48 to as low as £1 = $1.20 in January; as of 29 November it's hovering at around $1.34.
This has led to billions of pounds in extra income for UK shareholders. Capita estimates that the sterling value of UK dividends was boosted by 5.1% - or £2.5 billion - between January and June this year.
The second factor is the return of both miners and banks to the income fold after they underwent some fruitful corporate restructuring.
The third quarter was a bonanza for mining dividends in particular: the sector contributed more than £3 billion, or two-thirds of the total quarter-on-quarter increase, between July and September.
A pick-up in commodity prices from a two-year slump, combined with capital expenditure cutbacks, seems to be reviving the sector.
Similarly, banks are finally getting their houses in order following the financial crisis. Lloyds (LLOY)' return to the dividend scene has boosted the financial sector significantly.
Big fund winners in the UK equity income sector this year include Money Observer Rated Funds MI Chelverton UK Equity Income and Unicorn UK Income, which delivered total returns of 29 and 27% respectively in the 12 months to 31 October, and yields of 4.8% and 3.8%.
Interestingly, neither pound weakness nor mining or bank dividends are likely to have played a big role, as the bulk of both portfolios is invested in companies outside of the FTSE 100.
Instead, both funds have benefited from their managers' small-cap stock expertise, as UK smaller companies enjoyed a huge post-Brexit rally in 2017 (UK smaller companies is the top-performing IA sector over the past year, having returned 30%).
Funds that have benefited more directly from pound weakness and the mining and banking splurge include MAN GLG UK Income, which has returned 28% over the past year and whose top seven holdings include both Rio Tinto and Lloyds as well as two other FTSE 100 dividend favourites, Royal Dutch Shell (RDSB) and British American Tobacco (BATS).
It's a similar story for CF Miton Multi Cap Income, which has returned 16% and includes Rio in its top ten, and for Premier's income funds (Optimal Income, Monthly Income and Income), which have enjoyed a big boost from their large holdings in Lloyds (as well as in the oil and gas sector).
While dividends from Lloyds and the miners are arguably a fairly stable feature for UK equity income, the boost from post-referendum pound weakness is not.
According to Capita, investors need not be concerned, though, as currency gains since last June have now largely worked themselves out of the dividend growth figures.
The research house claims that pound weakness contributed just £58 million to dividends in the third quarter, with underlying dividend growth up 12.9% on a constant currency basis - the fastest rate of growth for any quarter since 2012.
Some managers, however, are less sanguine. Questioned about what keeps her awake at night, Karen McKeller, manager of the Standard Life Investments UK Equity High Income fund, says it's currency.
"In terms of things I worry about, if the dollar weakens significantly from here, that is a big negative for UK dividends. Of the key risks to UK dividends, number one is significant currency change," she says.
At the moment there is little to suggest a dollar dive, but with one of the most volatile (and impeachable) US presidents in history at the helm, it's not impossible.
Perhaps more concerning is the upward path of UK interest rates - the Bank of England hiked its base rate for the first time in a decade in November.
At its current level of 0.5%, the base rate poses little threat to the UK equity income sector - which has an average yield of 4% - in terms of outflows.
However, as Matt Hudson, manager of the Schroder UK Alpha Income fund points out, rising rates could boost sterling.
He says: "At the moment I don't think interest rate rises are anything to be concerned about, but they do affect sterling, particularly against the dollar, and that could have a big impact."
The long-term effects of a rate rise could be a bigger problem. Hudson points out that one major factor that has affected all income investors since 2008/09 is the fall in long-term bond yields.
This, combined with strong underlying performance, has provided a big boost to so-called 'bond proxy' income-paying stocks such as utilities and oil and gas.
But if interest rates begin a protracted upward path, these equity income stalwarts could suffer as bond yields are pushed upwards and lure investors back to fixed interest.
"I'm not arguing that bond yields are going to move up aggressively from here, [but] I think the structure of markets and returns is beginning to change," says Hudson.
Mixing it up
For equity income investors concerned that the tide may be turning for UK dividends, funds with a mid- or small-cap focus - which are less negatively affected by either a spike in sterling or a mass exodus from large-cap bond proxies - may be beneficial.
As already mentioned, MI Chelverton UK Equity Income and Unicorn UK Income both fit this bill, and both have solid long-term track records. In addition the Unicorn UK Ethical Income fund - which naturally excludes many potentially vulnerable FTSE 100 names - could be worth a look. Launched less than two years ago, it has returned 24% in the year to 31 October and yields 4.3%.
Equity income funds that are allowed to hold bonds, such as McKeller's Standard Life Investments UK Equity High Income fund, could also provide much-needed flexibility. Her fund is enjoying a sustained upturn after a period of underperformance.
Hudson's Schroder UK Alpha Income fund is also a potential contrarian pick. Having recently fallen out of Money Observer's Rated Fund list because of a disappointing couple of years, it has picked up again to deliver second-quartile returns over the past year.
What's more, it pays an above-average 4.5% yield, and Hudson says he is ready to boost his strategy to meet market conditions.
There is little reason to suspect that UK equity income is about to take a significant nosedive. While most experts agree that 2018 will be a slower year for growth than 2017, Capita expects distribution to be broadly in line with this year, while McKeller and Hudson anticipate growth of between 3% and 8%.
Of course, Brexit remains the biggest wild card. To date, the UK's decision to leave the EU has had little impact on markets, while economic growth has been more resilient than expected. Nonetheless, protracted negotiations could damage dividends.
In the meantime, though, UK equity income investors can look forward to another 'strong and stable' year.
Fund focus: Rathbone Income
Rathbone Income - managed by Carl Stick since 2000, more recently in tandem with co-manager Elizabeth Davis - has consistently made it onto the Money Observer Rated Fund list, thanks to its strong performance and long-term investment style.
Davis says: "The key in our view is sustainability. We are less concerned with the initial level of the yield, so long as the company is producing plenty of cash to support it."
The fund currently yields 3.8%, and it has a three-year total return of around 31% to mid-November. Davis says she and Stick expect fewer special dividends from companies overflowing with cash over the next year, but that this is no bad thing.
She adds: "If companies are seeing better investment opportunities, we are very happy for them to reinvest their cash rather than return it to us. In the long run, we as shareholders should benefit."
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.