INVESTMENT EXTRA: Dividends are the savers' solution

By BILL O'NEILL
Updated: 16:45 EST, 12 November 2010

Interest rates in the UK have never been lower in the Bank of England's 316-year history.

A deposit account pays virtually nil, government bonds yield just over 3 per cent, at best.

Consumer price inflation is 3.1 per cent, expected to rise to 3.4 per cent next year. So bond and deposit investors are going backwards. 

Income generator: The oil and gas sector is expected to yield 4.8 per cent next year, an increase of almost 50 per cent on 2010

Where does the saver go for income? Safer corporate bonds yield 5 per cent, high yield bonds 8.4 per cent, but these have had a good run, and high yield bonds carry significant risk.

UK equity dividends are in fact attractive. During the financial crisis and subsequent recession, companies cut dividends, especially banks.

This year, BP cut its dividend. Investors worry that lower dividends are a theme that will continue. They are mistaken. We believe this trend will reverse, and dividends will grow.

The health of UK companies is underestimated. UK companies are sitting on a mountain of cash  -  the result of prudent cash management during the financial crisis.

The Bank of England estimates that two-thirds of companies are holding 'above normal' cash levels.

Increasingly, there is pressure for that cash to be used, especially as it is yielding such low returns. Part will be reinvested in the business. Few companies plan to increase their cash holdings further.

Much of the cash will be returned to the owners of the business  -  the shareholders. This can be via dividend-increases or share buybacks. The current dividend yield for the FTSE 100 is 3.3 per cent.

Analysts expect dividends in the UK to grow by almost 20 per cent next year, taking the 2011 dividend yield to

3.7 per cent  -  that's above the current yield on 10-year UK gilts, and at this level the yield will be covered a healthy four times by companies' cash flow.

So where can investors find high growing and well covered dividends in the UK? The oil and gas sector is expected to yield 4.8 per cent next year, reflecting expected dividend growth of almost 50 per cent after this year's BP dividend cut.

Financials are another good but underestimated source of income. Insurance companies are forecast to yield around 5 per cent in 2011, and even banks' 2011 dividend yield is projected at over 3 per cent, especially now some of the regulatory restraints have been loosened.

For investors wanting to take less risk, the 2011 dividend yield for telecommunications is forecast at 5.7 per cent and healthcare 4.5 per cent.

All these sectors are very well covered by earnings and cashflow  -  companies have the profits and cashflow to fund the dividend payouts.

Dividends have a big impact on equity returns. Over the last ten years, the FTSE All-Share Index has fallen by just over 10 per cent.

However, the total return of the index that includes re-invested dividends has been more than 30 per cent.

There are, though, downside risks. Companies, aware of the recent financial crisis and limited access to credit, could elect to maintain cash levels at current levels, therefore not growing dividends.

Alternatively, the global economy could weaken. We do not think either of these risks will materialise. In fact, as the population ages, we expect companies to grow dividends, because that is what shareholders will want.

Additionally, share buybacks should begin to increase. With companies regarding their shares as cheap, expect a greater number of share buybacks in 2011.

This is a good way for investors to receive extra capital appreciation. Merger and acquisition activity has also recently started to spring back to life.

Companies will continue to use their cash war chests for takeovers which may increase the return to shareholders.

Companies have strong cash balances and equity investors are becoming increasingly impatient with the fact that this cash is yielding low returns.

There will likely be a strong push towards higher dividends going forward which, in a world where yield is a scarce commodity, will favour those choosing to invest in UK equities.

• Bill O'Neill is Chief Investment Officer of Merrill Lynch Wealth Management