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With dark clouds gathering over the markets, it would not be surprising if investors in the IMA UK Equity Income sector were running for cover. However, a recent spate of good dividend results may keep investors from the door for the moment.

With the uncertainty surrounding the course of the UK and global economies this year and next, investors in UK equity income funds, with their typically large-cap holdings, will find recent dividend increases extremely rewarding.

"At the moment, we are in incredibly uncertain times, but dividends are actually quite good," says Colin Morton, lead manager on Rensburg Fund Management's £238m UK Equity Income fund. "Barclays results have announced a 10 per cent dividend, while Lloyds had 5 per cent. There has not been any of the really bad signs, but the test will be over the next 12-18 months when things could potentially get worse."

Mr Morton's view may be right as the sector seems to be muddling by, with investors seeking solace in other positive company results such as HBOS. The mortgage lender posted slightly better-than-expected full-year profits. Underlying profits for the company in 2007 came in at £5.71bn, up 3 per cent on the previous year's £5.54bn. Net profits were 4 per cent higher at £4.1bn, though pre-tax profit dipped by 4 per cent to £5.47bn.

Credit crisis

Investors and managers in the UK Equity Income sector, one of the hardest hit last year, seem content to carry on, but most still cite the credit crisis and its possible effects as the only hurdle for the sector to get back on track. The problem for investors at the moment is if the market slowdowns continue.

Ian Lance, manager of Schroders' £875m Income fund, says the risk is ever present and much of the sector has now become divided. "The sector has become quite split as some income funds do exactly what they say, while others invest in stocks that yield less than the market," he says. "There are two subsets."

Mr Lance says he expects some equity income funds, in the long term, might be drawn into chasing yields by going after stocks such as banks and mining. Credit markets may continue to worsen, he says, and if they do, he expects further dividend cuts. But he does not think people have yet priced this possibility into the market.

Dividend results

Scott McKenzie, manager of Martin Currie's £141m UK Equity Income fund, agrees the next year could be difficult with the market downturn in full swing. But, at the moment, dividend results indicate otherwise. "It is fair to say 2007 was a very bad year for income funds, and most were hit in the second half of the year," Mr McKenzie says. "But results at the moment from companies such as BP, Shell, GlaxoSmithKline and Barclays give a sign of hope."

Martin Cholwill, senior fund manager for UK equities at Royal London Asset Management, agrees the credit crisis is the biggest concern for equity income investors. "There are a number of dangers, especially with the problems in the banks and the credit crisis," he says. "The problems with the banks is this may spread out into the further economy and negatively affect some of the big companies that UK equity income funds rely on.

"Previously, many of these companies had the option of refinancing or borrowing money if they were in trouble. But it looks like this is no longer an option and could be problematic further down the road."

What is certain is the free lunch enjoyed by the UK Equity Income sector is over. The last 10 years of outperformance is highly unlikely to be repeated, and investors will have to work harder to find quality funds in the market, while managers will have to tread carefully to avoid further pitfalls.

James Kenny is a reporter at Investment Adviser