By Daniel Grote of Citywire

The UK equity income sector has surged in recent months, buoyed by a challenging macro backdrop. Not only are UK rates at record lows – and likely to be anchored there for some time – but bond yields remain stubbornly low too. As inflation ticks up to 3%, investors are choosing equity income as a means of protecting themselves.

Yet that is only one part of the sector’s recent ascent. In the fourth-quarter of 2016, dividends rose by nearly 6.6% on the previous year, as the plunging pound offset dividend cuts earlier in the year.

Such increases have translated into greater success for UK equity income funds. In the past 12 months, for instance, the average UK equity income fund has returned 15.5%, according to Citywire data. This includes many funds paying a regular income in excess of 4%.

Given this, it is little wonder investors have warmed to UK equity income funds, with the sector enjoying £239 million in inflows in March, the Investment Association says. That makes it the fifth most popular sector of late.

So can this hot run continue? And what can we expect of dividends this year?

Maintaining momentum

Experts are divided on dividend momentum. Capita Asset Services, for instance, predicts dividend growth of 2.8% this year. But that is partially dependant on continued sterling weakness.

‘On the face of it, dividends look very healthy and dividend stocks look a good place to be in a world of low yields,’ argues Rory McPherson, head of investment strategy at London-based Psigma Investment Management.

But dig a little deeper, he says, and the picture is less rosy. ‘Whilst dividends grew in the order of 10-15% last year, much of this came from weakness in the pound. On a constant currency basis dividends in the FTSE ALL Share have shrunk by 1%; something of a red flag for investors.’

So companies coming from a much steeper baseline may not post the same year-on-year increases. Bigger names and so-called “bond proxies” could also experience capital losses if dividends fall and investors retreat.

Dividend selection

The prospect of potentially falling dividends poses a dilemma for managers: how can they find dividend growers while still achieving income of around 4%? In reply, managers will say they target 5% to 10% income growth with dividends around 4-5% – anything above this is likely unsustainable. But the reality is tough, if not impossible.

Whereas the average FTSE 100 dividend is likely to be around 4.2% this year, the dividend cover could be as low as 1.46 times, according to AJ Bell, a Manchester-based financial services firm. A dividend cover below two means a company has less room to manoeuvre, and cover less than one could see firms miss their dividend payments completely.

If profits fall or the pound accelerates, therefore, management could be forced to decide between reinvesting less, borrowing to pay dividends, or cutting them altogether, as many did in early 2016.

Meanwhile, half of the FTSE 100 projected dividends (£39 billion this year) are forecast to come from just 7 companies. At the same time, the 10 companies with the highest projected dividends have an aggregate dividend cover of just 1.17 times. This means many of the biggest companies are on somewhat shaky ground, and investors can ill-afford to focus solely on headline dividend numbers.

For others, smaller companies with bright prospects is a novel solution. Psigma’s McPherson explains: ‘at the moment we’re holding more of the smaller companies in the FTSE All Share. Smaller companies are currently investing more in CAPEX than their larger counterparts which helps make for good and growing dividends long-term.’

Experts maintain the strategy will remain popular given the challenging backdrop, however. ‘Provided interest rates stay low globally then dividends will remain a powerful return source,’ explains Mark Lane, an analyst at Standard Life Investments. ‘Especially in in an environment where baby-boomers are retiring. And I don’t see rates going up soon.’

This article is independently written by Citywire and not subject to editorial oversight by Blackrock