Seeking yield in UK equities

By their nature, income investors aren’t known for their risk appetite. Rather than hunting for hot new trends, dividend hunters have tended to stick to the same process: backing time-tested assets in pursuit of reliable yields that will benefit from compounding.

For years, this method has held up. And then along came Covid: a macro shock that overturned the certainties of dividend investing. Many of the most reliable payers – some of whom had paid out for decades – were forced to slash their dividends. As fears of a financial crisis rose, banks were blocked from paying out. Bruised investors found themselves chasing a vanishing pool of potential yields.

Two years on and normality looks to be resuming – at least from above. According to one analysis (published by S&P Dow Jones Indices), around one third of the US blue-chips who suspended their dividend have now reinstated them, with more set to do so before long. In the UK, meanwhile, the FTSE 100 is tipped to deliver a healthy-looking average yield of 3.7pc.

Yet look under the surface and it’s clear that, even as markets remain buoyant, yield investors face a very different picture from two years ago. A climate of elevated asset prices, continued macro uncertainty, and the shifting definition of ‘safe haven’ will all likely weigh heavily on any income-strategy, and not just in the short term.

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First off, valuations. While traditional dividend stocks – banks, energy majors, consumer staples – may not be obvious beneficiaries of the tech-driven bull-market that took hold in spring 2020, there’s no denying their prices have risen sharply. In many cases, dividend-paying stocks now exceed their pre-Covid valuations.

If those valuations prove to be sustainable, that won’t be a problem. But you don’t have to be an obsessive pessimist to take the opposite view. Could it be that the exuberant bull market in growth equities has shifted the gravity of markets more generally, inflating income stocks in its wake? And, if so, what happens if it runs out?

These questions present problems for all investors – but for income investors there is a particular risk. While single-figure yields might provide a fruitful investing strategy in a stable market, they are less useful in a turbulent one. Put simply: what good is a 6pc yield on a stock that then drops 20pc of its value?

If the possibility of a Covid- or inflation-inspired market correction weren’t enough to worry yield-seekers, there are other factors to consider too – many of which remain particularly pertinent to blue-chip dividend-payers.

Take ESG, for example. While oil majors and mining stocks have long been a portfolio staple for income investors – with some of the latter even managing to maintain their pay-outs in 2020 – their evergreen shine looks a little less bright in a market increasingly driven by environmental concerns.

For their part, BP and Shell – the FTSE’s biggest energy companies and long-term dividend stalwarts – have both published ambitious plans to ‘go green’, investing heavily in low-carbon technologies. It’s the feasibility of these projects, analysts say, which will determine their future profitability. Meaning that investors will need to do their ESG homework.

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How about the FTSE’s non-energy dividend payers? Banking shares recently received a jolt when Threadneedle St overturned its temporary ban on paying dividends. And with expected yields of 3-4pc (with some forecasters predicting a tantalising 6pc), you can see why some income investors might be rushing back to the sector.

A safe bet? With markets still hyper-sensitive to inflation data, banking shares may well experience a rocky autumn. Yet many analysts point out that, while this short-term noise will affect valuations, investors can take comfort in the solid balance sheets which underpin the likes of Lloyds and Natwest. Which should help protect those payouts. 

The broader consumer sector looks strong too: with Unilever, Burberry and Diaego forecast to yield 3.93pc, 2.22pc and 2.08pc respectively. Tesco, meanwhile, comes in even higher, with an expected yield of 3.93pc – and a valuation that looks seriously cheap compared to its FTSE competitors. Even better, it’s dividend looks safe too.

And what can yield-seekers do to prepare the worst? Pre-2020, many will have operated on the assumption that – when growth expectations underwhelm – investment flows will inevitably head towards safe havens: making fixed-income bond funds, in particular, a savvy investment in an economic downturn.

But on that front, too, investors face a changed environment. After a turbulent year (which has seen bond funds swing between large outflows and inflows), bond prices remain volatile, as markets predict that inflation will prove more stubborn than policy-makers expected.

All in all, the end result is a mixed picture for income investors. Unless markets face a major upset, there will certainly be yields to be had. Investors just might need to tread slightly more carefully than they used to.


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