Income investing – five shares for a low interest rate world

FTSE 250 water utility group Pennon offers an inflation-linked dividend with the potential for extra growth outside its core business. The prospective yield is currently 4.4%.

However, Donald Trump’s victory has raised expectations of interest rate rises in the US, which has pushed up yields in the bond market and led some income investors to drift away from shares and back into bonds.

Nonetheless, utilities typically offer stable earnings and we are confident in the group’s prospects. Sector-leading returns on regulated equity support a generous dividend policy. The group plans to increase its payout by the rate of RPI plus an additional 4% each year out to 2020 although of course there are no guarantees.

With inflation expected to jump this year, provided Pennon can stick to its targets, investors could get some impressive increases at a time when returns on cash accounts are lagging behind the rate of inflation. This is the reason we also chose the stock as one of our five to watch in 2017.

Around a fifth of profit comes from Viridor, Pennon’s waste management business. The group expects to generate £100m of profit from energy recovery facilities (ERFs) this year, and recently invested in a £252m plant in Avonmouth. This division means that the group offers something different from the other utilities, although it does add extra risk.

Pennon share price, charts and research >>

Pinning down a reliable income has become increasingly difficult. In recent years, record low interest rates have put paid to many high interest cash accounts, while yields on bonds and gilts have been compressed too.

However, over this time, the UK stock market has continued to offer attractive opportunities. The final quarter of 2016 saw a record £16.6bn paid out in dividends. Below we highlight five companies already offering reasonable prospective yields, and which we believe offer the potential for dividend growth in the future.

Please remember that dividend income can vary and is not guaranteed. In contrast to cash deposits, your capital is at risk when investing in the stock market, so your investments can fall as well as rise in value and you could get back less than you invest. Past performance should not be seen as a guide to future returns.

Important information: This guide is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters and are correct as at 7 March 2017. These estimates are not a reliable indicator

of future performance. Yields are variable and not a reliable indicator of future performance. Investments and income rise and fall in value so investors could make a loss. If you invest in individual shares listed on the stock market please be aware shares can be delisted at any time, sometimes with no prior warning. If this occurs it may be difficult and costly, or even impossible, to sell your shares. This guide has not been prepared in accordance

with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

PENNON – AN INFLATION-BEATING DIVIDEND

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017(est)

2018(est)

Pennon dividend per share (pence)

One College Square South,Anchor Road, Bristol, BS1 5HLwww.hl.co.uk

Source: Thomson Reuters Eikon, 7 March 2017. Past performance is not a guide to future returns.

GEORGE SALMONEQUITY ANALYST

George Salmon holds shares in Lloyds Banking Group, Pennon and Astrazeneca.

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A number of years’ underperformance mean that AstraZeneca shares currently offer a prospective yield of 4.7%. However, with a tough couple of years behind it, there are reasons to believe that the global pharmaceutical giant could be set for a recovery.

Blockbuster drugs have lost patent protection, meaning cheap generic versions of previously lucrative drugs have become available elsewhere. Astra has responded by cutting operating costs and increasing investment in its development pipeline.

Progress has been made in some areas already, with sales of new drugs to help treat lung cancer (Tagrisso) and heart problems (Brilinta) increasing rapidly. However, despite this growth, analysts still expect overall earnings to fall slightly in 2017, which means investor focus will be on what is still to come out of the labs. The potential for serious developments here make it another of our five shares to watch in 2017.

Head and neck cancer trials have been resumed after a temporary suspension in October, but it is the results of the Mystic trial which will attract the most attention. Results from late stage trials for the new lung cancer treatment are expected in the coming months. Some analysts believe even a partially successful outcome could generate revenues of $7bn a year –

although others remain sceptical about the chances of success. The Mystic results will likely make or break performance in the near term.

AstraZeneca share price, charts and research >>

In recent years banking has been anything but dull, much to the annoyance of investors and the wider public. While Lloyds is not alone in saying it’ll be playing with a much straighter bat in the future, it is ahead of its competitors in its transformation.

Looking ahead, misconduct fines should fade into the background, while volatile investment banking and corporate finance revenues have declined dramatically. Profits are now being driven by steadier high street banking, SME lending and personal finance.

Since the crisis, the bank has remodelled itself as a slimmer, more efficient operation with digital banking at the fore. Trimming costs has helped maintain its industry leading cost to income ratio.

Those low costs mean the bank is generating plenty of surplus capital. When combined with the group’s strong capital base (Lloyds comfortably passed the most

recent round of stress tests) that’s not only seen ordinary dividends resume, but brings about the potential for more special dividends.

The acquisition of Bank of America’s MBNA credit card business used up some of 2016’s excess capital, but the bank has previously stated its intention to return

any surplus to shareholders in future. The shares offer a prospective yield of 5.5% and analysts expect the payout to grow in the coming years, although of course there are no guarantees.

Lloyds share price, charts and research >>

ASTRAZENECA – NEW DRUGS, NEW PROFITS?

LLOYDS – GOOD BANK BEATING BAD BANK

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AstraZeneca earnings before interest, tax, depreciation and amortisation ($bn)

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Lloyds HSBC Barclays RBS

Major UK banks’ cost:income ratio

Source: Thomson Reuters Eikon , 7 March 2017

Source: Lloyds Banking Group, HSBC, Barclays and RBS 2016 annual results.

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Security of future revenues is also one of the main attractions of real estate investment trust Tritax. The group leases out those vast, looming warehouses adjacent to the UK’s motorways, which play crucial roles for the retail giants that rent them out. The shares currently offer a prospective yield of 4.3% according to Bloomberg.

Retailers’ distribution networks are built around these facilities, which often act as regional logistical hubs. With online sales on the rise, these facilities are invaluable to many. Some retailers have even negotiated new arrangements early to ensure that they don’t lose the lease in the future. Electing to move elsewhere can prove costly, after all the investment that goes into the whirring high-spec equipment that makes the centres run at top efficiency can be significant.

As a result, the group clearly has the upper hand when negotiating terms. Upwards only rental reviews are often a feature of

Tritax’s agreements. The group’s portfolio of 35 sites is worth around £1.9bn and has an average unexpired lease term of just over 15 years.

With a REIT legally obliged to distribute

90% of its profits, we feel that it makes for an attractive income play.

Tritax Big Box share price, charts and research >>

As with Astrazeneca, the bulk of BAE’s revenue comes from overseas. This means that sterling’s decline has boosted expected earnings per share. With a policy to pay out around half of earnings as dividends, the prospects for higher returns has been lifted. The shares currently offer a prospective yield of 3.4%.

However it’s not just the currency effect that makes BAE an attractive option. Donald Trump’s victory has caused many to revaluate their view on the world, with perspectives in the defence sector shifting considerably.

His plans to boost US defence spending to the tune of $54bn have certainly made investors sit up and take notice. Replacing, upgrading and expanding the equipment in the US military certainly won’t come cheap, and BAE has historically been at the front of the queue for many US defence deals.

With the order backlog stretching to £42bn of business already, should the group get a bump from Trump, it would only serve to increase the pipeline of future revenues.

BAE Systems share price, charts and research >>

TRITAX – A SWEET REIT

BAE SYSTEMS – CHOCKS AWAY

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Tritax Big Box Net Asset Value per share (pence, LHS) and number of assets (RHS) since listing

USA 38%

UK 23%

Saudi Arabia 22%

Rest of Europe 12%

Other 6%

BAE Systems source of revenue by geography (to nearest 1%)

NAV Number of assets

Source: Tritax Big Box 2016 annual resultsPast performance is not a guide to future returns.

Figures for BAE 2015 results, taken from Thomson Reuters Eikon, 7 March 2017

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