Dividends remain more popular than bonds

As a result, the equity income sector has become increasingly popular as the yield from company shares has proved more attractive than bonds.

The FTSE All-Share index’s current dividend yield of roughly 3.6 per cent is slightly better than its long-term average, and crucially is better than the 10-year gilt yield of around 1.9 per cent.

It is no surprise that the Investment Association’s UK Equity Income sector has been one of the top sellers in the past two years. This is likely to continue for the time being, considering that the US Federal Reserve has decided to hold its interest rate steady in spite of months of anticipation of an increase.

However, the current market and economic environment creates challenges for equity income investors as moderate global growth, tumbling commodity prices and the fallout from a supermarket price war have dented profits among the UK’s largest firms.

Dividends can fall as well as rise, and even the most promising companies can suddenly reduce their payouts. This year alone we have seen Tesco, Morrisons and Centrica cut their dividends, while many others now appear to be under threat.

Indeed, the sharp fall in commodity prices has caused a degree of pain for many companies that have come to be known for their dividend yield.

In the 12 months to October 31, the FTSE 350 High Yield index underperformed – with dividends reinvested – the FTSE All-Share index by 6.9 per cent. Companies in the basic materials and energy sectors constitute 25 per cent of the former index.

Glencore stands out as an example of a miner that has seen its high fortunes – and high dividend – suddenly evaporate as a result of plummeting commodity prices. The company had a projected yield of 7 per cent prior to cutting its dividend.

Meanwhile, business support services group DCC has a fairly low dividend yield of 1.7 per cent, but it has generated annualised dividend growth of nearly 18 per cent in the past five years, as well as solid capital growth.

In the current environment, a barbell strategy is one way to achieve yield while side-stepping the pain being felt by higher-yielding companies.

This approach involves holding a relatively large number of companies that have higher-growth characteristics but fairly low-dividend yields.

In this case, a portfolio manager needs to determine whether to chase a high-dividend holding or stick with those that offer lower, well covered and rising dividends, as well as a degree of capital growth.

Even though developed economies have made great strides in the past seven years, the fact remains that the global economy still faces challenges.

Global growth is sluggish and uneven, government debt levels are elevated and the emerging market economies have been struggling, particularly China.

These factors taken together have given central bankers reasons to remain dovish. When interest rates do begin to rise, it will probably be at a gradual pace.

As interest rates go up, so will bond yields, but the crucial point to remember is that they will continue to be at historically low levels for some time to come. This means that investors will continue in their hunt for income, with equity income remaining viable for those willing to accept the risks.

David Marchant is chief investment officer and head of Canada Life Investments