Investors eye stocks for income strategy

This article is part of
Equity Income - April 2015

At a time of low yields on investment-grade bonds, investors are recognising that fixed income cannot meet all their requirements for income.

One alternative is to explore the opportunities offered by dividend-paying stocks, particularly those with scope for future dividend growth. Their ability to offer secure income combined with a degree of inflation protection should provide attractive long-term returns.

Bonds have traditionally been the asset class of choice for those seeking secure income. However, the era of ultra-low interest rates has created challenges for savers and institutions searching for secure income, as bond yields in core western economies have been declining in the past 30 years.

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Asset classes that can be owned in perpetuity have obvious advantages as population life expectancies extend. They may offer growth potential too, both in the capital value of underlying assets and in the scope for distributions to grow into the future.

Dividend-paying equities are such an asset class and have effectively moved into the territory that bonds once occupied because of the way in which they can deliver an income stream. Owning the rights to productive assets also offers a degree of inflation protection in a way that owning the rights to defined future cash flows cannot.

Although most equities are riskier than most bonds, UK studies have shown that the volatility of returns from equities might be lower than the volatility of returns from government securities across longer timescales after inflation. This reflects the way in which changing inflation expectations affect the present value of bond holdings, sometimes dramatically.

In fact, investors in gilts have, on average, experienced higher volatility combined with lower annualised real returns than investors in equities, if invested for more than a decade, according to the Barclays Equity Gilt Study 2014. Investors with longer-time horizons need to give these implications serious thought.

In an environment of yield compression in fixed income and global macroeconomic uncertainty, the potential attractions of an equity income strategy are clear. Investing in shareholder-friendly, dividend-paying companies around the globe has delivered lower volatility and higher returns compared with the wider global equity universe.

Dividend-paying firms are plentiful, too. There are more than 350 listed companies that yield 3 per cent or more in the MSCI All Country World index, and others yielding 4 per cent or more in the Euro Stoxx index. Established cash-generative businesses can indeed provide secure income.

When selecting stocks for their dividend characteristics, there are two key features to bear in mind. First, the sustainability of distributions, particularly as an unprecedented number of firms have taken advantage of the historically low cost of debt to refinance and begin share buybacks. Second, the potential for distributions to grow.

In the past, companies that have been able to grow their dividends across a number of years have generated superior total returns when compared with those that pay flat dividends, declining dividends or none at all.