Investors who want to generate a rising level of income will normally allocate a significant part of their portfolio to funds operating in the UK Equity Income sector. These have delivered strong historic returns, but in many cases the underlying dividends are looking increasingly stretched.
Recent research by Kepler Trust Intelligence found that just under 30% of the £62 billion held in open-ended funds operating in this area was invested in just 10 stocks that had an average dividend cover of 1.04 times earnings.
Dividend cover measures the extent to which the annual profits of a company exceed its dividends and provides an indication of whether the business would be able to maintain its distribution in a poor year. The stats suggest that it wouldn’t take much of a decline for many of these major holdings to have to reduce their dividends.
UK Equity Income investment trusts have more flexibility as they can use their revenue reserves to maintain their distributions even if some of the underlying holdings have to cut back, but they would still be vulnerable if investors lost confidence in the large dividend paying UK stocks.
One way to guard against this would be to switch part of your portfolio to high yielding funds that invest in overseas equities. Some of these are available on sizeable discounts that provide an element of downside protection.
A good example is the Aberdeen Asian Income Fund (LON:AAIF) that has just released its annual results for the 12 months to 31 December 2017. AAIF invests in Asia Pacific securities and generated a NAV total return of 16% last year.
Some of these funds are available on sizeable discounts that provide an element of downside protection.
The management team acknowledges the increase in market volatility in the first few months of 2018 and accepts the risks from protectionism, trade wars and central bank tightening. Despite this they believe that the strong fundamentals, structural reforms and favourable demographics make Asian equities more attractive than their developed market counterparts.
Aberdeen Asian Income is yielding 4.4% with quarterly dividends and is trading on a 9.6% discount to NAV.
Middlefield Canadian Income (LON:MCT) invests in Canadian equity income securities and selected US companies that offer attractive and growing dividends and the potential for capital growth. The pay-out ratios of Canadian stocks are more conservative than their UK equivalents at about 70% of earnings.
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MCT is yielding 5.5% with quarterly dividends and the shares are trading on a 12.7% discount to NAV. Its future performance will depend on the strength of the US and Canadian economies and the oil price – Canada has many energy companies – as well as the results of the renegotiation of the North American Free Trade Agreement (NAFTA).
Another option is BlackRock World Mining (LON:BRWM), which invests in a global portfolio of mining stocks. The sector has had a poor start to the year, but the managers are optimistic and believe that the strong balance sheets and high free cash flow yield will ultimately lead to a positive re-rating.
BRWM has recently started to pay a quarterly dividend and is yielding an attractive 4.3%. The shares are trading on an 11.4% discount to NAV.