Investors shun bonds for dividend-paying stocks

The hunt for yield has drawn investors towards less well-understood asset classes in fixed income, for instance, but equity remains a potential source of attractive income.

At one point this year, $4trn (£2.6trn) of debt globally traded at negative yields, and at their lows French, German and Swiss sovereign yields were negative out to five, nine and 15 years respectively.

By the end of last year, roughly 52 per cent of all global government bonds yielded 1 per cent or less, forcing investors to seek alternatives. This can carry greater risk as investors are pushed down the liquidity spectrum or out along the risk curve in their pursuit of returns.

As bond yields have plunged to historic lows and the global outlook has become increasingly uncertain, the lure of dividend-paying stocks has increased.

Renewed interest in these stocks has come at a time when companies have been able to pay shareholders record amounts as their cash piles have swelled – US corporate cash holdings grew to a record level in 2014.

The availability of cheap credit has meant firms have been able to borrow heavily and lock in low rates. Balance sheets have ballooned, helping to underpin dividends and fund share buybacks.

Dividend payouts reached a record $94bn among S&P 500 companies this year, according to S&P Dow Jones Indices.

Stocks in Europe, the UK and the US have all struck record or multi-year highs in 2015 before falling back recently on emerging market concerns. In the UK, small- and mid-cap stocks have been outperforming the shares of blue-chip firms as the UK economy fires on all cylinders and international developments have been less benign.

This has effectively boosted the performance of the average UK equity income fund, given their skew to mid- and small-cap stocks.

The FTSE 100 index’s heavy weightings in challenged sectors, such as oil and mining, and the relative strength of sterling against the euro have dampened sentiment. However, companies have responded by cutting costs and capex in part to maintain their dividend-paying capabilities.

Share price falls have left many stocks on historically high yields. The case for diversifying equity income investments by including funds with more emphasis on large-cap stocks is compelling in the current environment.

Large-cap stocks also open up another potential source of income, through the writing of call options, which is much less available to mid- and smaller-cap stocks. Writing call options over stocks held can generate additional income in the form of premium received, while still participating in share price appreciation up to the option strike prices.

Equity income strategies that bring together a large-cap emphasis with a call option overlay can potentially generate a yield of around 7 per cent. To achieve similar yields, traditional income funds would have to be heavily skewed to very high-yielding stocks, which carries a different set of associated investment risks.

Diversification should be one of the key considerations for any portfolio and large-cap focused funds can help with respect to equity income investments.

Matthew McKelvey is head of product management, specialist equities, at Insight Investment