Investing for yield

With interest rates at just 0.5%,  investors are looking for more profitable things to do with their funds than keep them in cash. While corporate bonds have been a popular destination for investment, equities look undervalued from a yield perspective - and offer the prospective of increasing returns over the medium term.

For the past fifty years, equities have generally yielded less than bonds. They're not as safe, since dividends can be varied at the will of management - unlike interest paid on bonds - but since the companies are expected to grow, investors get a dividend that should grow over time, giving them a hedge against inflation.

Up till now the only time that the yield gap reversed, with equities yielding more than bonds, was 2003 - and the reversal acted as a clear 'buy' signal.

The ten year gilt yield is now 3.65%, not far off its record low of 3% reached earlier this year, while the yield on the FTSE All-Share index is 3.8%. Not as cut and dried as it was earlier this year, but still suggesting equities are undervalued.

Defensive stocks such as the utility companies are an obvious place to look for dividends. Reputed fund manager Neil Woodford, of Invesco Perpetual, believes these are the best investments this summer - his funds are defensively positioned in pharmaceuticals, tobacco and utilities, which have “resilient business models” and which he believes are undervalued.

Utilities have underperformed since the start of the bull rally as investors have looked for stocks better geared to recovery. Some offer excellent yields - Scottish & Southern Energy for instance sits on a 5.7% historic yield, United Utilities offers 6.8%, and National Grid 5.8%. Cash flow is strong, and most are expected to increase their dividends this year. However, it's worth remembering that most of the utilities are at the mercy of government regulation - which could dilute their returns to shareholders if the pricing regime toughens.

Telecoms stocks have some of the same characteristics, though BT Group spoilt the sector's image with its exceptional writedowns on its global services IT business, which forced a huge cut in dividend. The market has priced that in - BT Group offers a yield of over 5%, and £VOD  nearly 6%.

It's worth looking down the list for some lesser known bargains - Telecom Plus yields 5.8%, though the dividend is rather thinly covered, and has a good record of growth as a low-cost competitor to the majors.

Tobacco is another area Neil Woodford likes, with only two stocks - Imperial Tobacco Group and £BATS. These offer historic yields of 3.6% and 4.3% respectively, sit on low-teens multiples, and have strong cash flows. They are both expected to increase their dividends, and have a satisfying track record. As anyone who is, or knows, a nicotine addict can tell you, spending on ciggies is one of the last household expenditures to be cut. BATS in particular has a geographically diverse income stream and offers exposure to emerging as well as developed markets.

Nomura points out that the dividend yield on many utilities and telecoms stocks is now higher than the yield on their bonds - a clear signal to buy. Add to this the counter-cyclical attractions, and if you think there's a risk we may get a double-dip recession, these stocks look like bargains.

There are also some excellent dividend yields available in sectors that offer a higher risk/reward ratio, being more highly geared to an economic recovery - but also more at risk if we get a 'double dip' recession.

Income investors who stayed away from the banks over the last couple of years (and there are some) will have done well, but could this be the time to think about getting back into the banking sector?

In this sector you do need to do your homework. There appear to be some massive yields available - Lloyds Banking Group offers 10.6% and £AIB 11.79%, if you believe the historic figures, but Lloyds will probably cut its dividend massively, and AIB's not expected to pay one at all. Best bet for income investors is £HSBQ at 5.1% - but even here, the historic income is misleading, as the dividend will be cut this year.

Much more interesting for yield investors who want some upside exposure is the property sector. From the peak of the commercial property market in 2007, values dropped nearly 40%, while the IPD commercial property index shows rental yields of nearly 8%.

Many of the UK's property stocks are now REITS (Real Estate Investment Trusts). They have to distribute 90% of their rental income (as defined by the government) or give up their REIT status - so if they can pay dividends, they will. The basic business of investing in property generates strong, long-term cash flows, which should support the yields of 5-6% that are common throughout the sector. British Land Co Plc pays 6.9%, Land Securities Group Plc 8.65%, and Hammerson Plc 6.5% historic - though some dividends are being trimmed, so do your own research!

Some of the smaller specialist REITS are interesting, too, with Primary Health Properties, which owns health centres, paying over 5%.

There is some downside. Since March, the sector has done well, and a number of the stocks are trading at premiums to net asset value, which exposes investors to some risk if the underlying values fail to rise over the next year. Equally, though rental levels appear to have stopped falling, voids are up - diluting the apparently good returns. None the less, institutional investors are getting stuck in, so perhaps private investors too should take a look.

Finally, let's take a look at two stocks which offer the best of both worlds - great yields and cash flow together with potentially good growth. Pharmaceutical majors Glaxosmithkline and £AZT offer 4.8% and 4.5% historic yields, with dividends expected to rise and well covered by earnings.

Successful income investing is not easy - particularly at this stage of the economic cycle. Just buying the yield is not enough - dividends can be cut or completely destroyed if the company hits the skids. Some sectors have seen most of their constituent companies stopping their dividends - for instance in pubs, Punch Taverns, Enterprise Inns, and Wetherspoon(j.d.) all now sit on a yield of either zero or very close to it. If a dividend yield looks exceptionally high, it's usually because the market is predicting a cut.

Looking at dividend cover (the factor by which earnings per share exceeds the dividend paid) can help sort out those companies which are overstretched. The wise investor will also look at the balance sheet backing up the dividend - how high are distributable reserves? And is the company's gearing so high that it might be tempted to omit the dividend in order to economise on cash?

Still, with the right research, income investing can be highly profitable. You'll get a regular,  growing income - and in the long term, if you've selected the right companies, it's highly likely that you'll get capital growth, too.

References:

• St James's Place UK High Income Fund report, http://www.sjp.co.uk/gear/library/documents/.../fact_ut_SJP_ukhiinc.pdf
• Reuters report, 7 September 2009: http://uk.reuters.com/article/idUKL762787520090907
• FT.com, 11v September 2009: http://www.ft.com/cms/s/2/3f3787ae-9eed-11de-8013-00144feabdc0.html 
• IPD, http://www.ipd.com