How does a 5% return on your money sound right now? With UK interest rates showing little sign of increasing from rock bottom levels despite mounting inflation, a 5% rate is certainly appealing.

If you are using your investments to pay the bills or to fund your living expenses in retirement the income you receive is vital. The great news is that the dividends from stocks and shares can offer investors a much better level of return than cash in the bank.

At the time of writing the FTSE 100 trades on a prospective dividend yield of 3.2% according to data from Stockopedia. Investors don’t have to settle for that return.

There are plenty of options which should pay a substantially higher level of income and Shares has trawled the market to find the most attractive stocks and investment trusts with yields of 5% or more.

LOOKING FOR INCOME PROTECTION

The danger with higher yielding investments is that the income may not be sustainable, and many of us may well have been burned in the pandemic when many businesses cut or paused their shareholder payouts.

It is hard to account for this type of Black Swan event, however we have attempted to introduce a measure of safety to our high-yielding selections in two ways.

First we have screened for stocks yielding 5% or more which have both forecast dividends covered at least 1.5 times by forecast earnings, with evidence that the last dividend was covered entirely by free cash flow (i.e. not being paid out of debt or by selling assets).

Second, our list of income plays is dominated by investment trusts and REITs (real estate investment trusts), which generate yield from a diversified portfolio of assets, negating the risk posed by an unexpected drop in income.

Investment trusts are also able to put by 15% of the cash they receive each year from investee companies as revenue reserves which can then be drawn on in trickier times to smooth out dividend payments.

The first table, created using data from SharePad, shows a list of stocks with prospective yields of at least 5%, forecast dividend cover of 1.5 times, and historic free cash flow dividend cover of at least one times.

The list is dominated by financials and mining firms. Interestingly while higher yielding businesses are thought to generally offer less sustainable dividends with limited scope for dividend growth, three names on the list, life assurance funds consolidator Phoenix (PHNX), tobacco firm British American Tobacco (BATS) and asset manager Jupiter (JUP), feature in the top 10 holdings of the SPDR S&P UK Dividend Aristocrats ETF (UKDV).

This ETF tracks an index which includes the top 40 highest-yielding UK stocks with consecutive years of stable or increasing dividends.

From the larger group we have identified British American Tobacco, Diversified Energy (DEC) and Phoenix as particularly attractive high-yield investments.

THE ETHICAL QUESTION

Two of these firms are engaged in non-ESG friendly sectors in tobacco and oil and gas respectively. For investors comfortable with investing in these areas these stocks look to be compelling dividend plays.

If you want a more ethical feel to your income investments there are several options in the investment trust and REIT space, with vehicles investing in renewables assets and healthcare facilities.

And another name could soon be added to the list as a new investment trust is looking to join the UK stock market, potentially offering generous dividends. Responsible Housing REIT wants to raise £250 million to invest in supported housing. The BMO-managed fund will target a 5% yield on its issue price when it is fully invested.

The second table shows a selection of trusts and REITs which have averaged a 5% dividend yield over the last five years. We have weeded out anything too niche or esoteric but still have a pretty big universe to choose from.

Our favourites are AEW UK REIT (AEWU), GCP Infrastructure (GCP), Henderson Diversified Income Trust (HDIV), Merchants (MRCH), Shires (SHRS) and Twenty-Four Select Monthly Income Fund (SMIF).

The average yield offered by our highlighted stocks and funds (based on forecast yield for the stocks and five-year average yield for the trusts and REITs) is a generous 7.1%, or £71 per year on a £1,000 investment.

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5%+ yielding stocks to buy

British American Tobacco (BATS) £27.29

Prospective dividend yield 8.1%

Investing in a company that specialises in the production of combustible and non-combustible tobacco products may be at odds with some investors’ ethical and social considerations. However, for those who can look beyond these moral ruminations, British American Tobacco (BATS) offers an attractive 8.1% dividend yield. Critically the dividend is well covered, with earnings expected to be 1.5 times greater than  the dividend payment.

During the group’s recent interim results presentation management reiterated its commitment to a 65% dividend payout ratio (the proportion of earnings paid out in dividends). Earnings growth for the group is underpinned by its considerable emerging markets exposure, particularly in Latin America and Asia, and America where it continues to command a price premium versus its competitors. The underlying strength of the business is reflected in the robust nature of the group’s operating margins that are just shy of 40%.

British American Tobacco anticipates revenue growth at constant currency in excess of 5% for the full year, and mid-single digit earnings per share growth. Broker Morgan Stanley expects dividends to increase by a consistent 3% annually over the next three years. [MGar]

DIVERSIFIED ENERGY (DEC) 108p

Prospective dividend yield: 10.8%

Normally a double-digit dividend yield would be a clear sign that the dividend is unsustainable at current levels. However, we don’t think that is the case at Diversified Energy (DEC) and believe there is scope for the payout to grow further.

The company’s strategy is built on acquiring conventional natural gas assets, initially with a focus on the Appalachian region but recently expanding its focus into Louisiana, Texas, Oklahoma and Arkansas.

Diversified aims to buy long-life assets where production declines slowly to underpin visibility on cash flow and, in turn, on dividend payments. A focus on lower-carbon gas also makes it less vulnerable to future policies looking to limit emissions.

The company secured additional firepower for deals through a November 2020 agreement with specialist asset management firm Oaktree Capital which committed to a $1 billion outlay to be matched by Diversified.

While the company has used debt to fund its M&A activity, a net debt to earnings ratio of less than two times looks comfortable given the levels of cash generation. Diversified paid out dividends of $64 million in the first half, up from $47 million for the same period in 2020.

Production in the first six months of the year reached a record 106,000 barrels of oil equivalent per day and the company has unveiled deals totalling more than $600 million so far in 2021. Investors should be aware the dividend is declared and paid in dollars. [TS]

PHOENIX (PHNX) 627.2p

Prospective dividend yield: 7.7%

Since it floated in 2009 the company has an unblemished target of matching and often beating cash targets and this has underpinned a reliable dividend.

The bread and butter of the business is its Heritage arm which manages life assurance products which are no longer actively marketed to customers and this has been built up through the acquisition of legacy insurance brands.

This allows Phoenix to focus all of its energy and expertise on improving the performance of funds without being distracted by the need to win new customers.

Its Open business does, in turn, actively sell products and services which help clients plan for retirement.

In the first half of 2021 the Heritage arm accounted for more than 70% of operating profit. Acquisitions across both units help to grow the level of business and therefore cash flow, supporting higher dividend payments.

Having picked up Abrdn’s (ABDN) (then Standard Life Aberdeen) life insurance business in 2018, the company acquired the Standard Life brand earlier in 2021.

Investment bank Berenberg comments that the current yield ‘is not reflective of the resilient and dependable cash generation of the business, which we believe can sustain the current dividend for a significant number of years’. [TS]

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5% YIELDING TRUSTS TO BUY

AEW UK REIT (AEWU) 106.4p

Five-year average dividend yield: 7.4%

Value-based property investment

Launched in May 2015 this real estate investment trust targets an 8p per share dividend and an attractive total return from investing in a portfolio of smaller commercial properties in the UK.

It believes it can find compelling value opportunities in this segment of the market as more modest sized commercial buildings, particularly those let on short leases, often trade at a discount.

The company does plenty of work on its assets to grow the level of rent and their capital values, principally by re-letting them.

It has a decent track record and its ability to generate an uplift in valuations was recently reflected in the £16.7 million sale of an industrial estate in South Kirkby and warehouse in Basingstoke which represented a 74% increase over the acquisition cost of the two assets.

Commenting on the transaction Numis said: ‘We believe it is positive to see management’s willingness to reduce this (industrial) weighting slightly by crystallising the profit realised on two strongly performing assets where it believes value has been maximised.

‘In recent months, the company has acquired two retail assets at net initial yields of 8.7% and 8% and we understand that management is assessing further opportunities in the retail space with low capital values and attractive entry yields.’ [TS]

 

GCP Infrastructure (GCP) 106.75p

Five-year average dividend yield: 6.8%

Get income from infrastructure loans

Infrastructure is often seen as a good long-term source of income as it generates predictable returns based on assets whose economic lives often run into decades. Also, it is not typically affected by ups and downs in the economy.

GCP Infrastructure (GCP) focuses on projects with long-term, public-sector-backed, availability-based revenues and where possible looks to incorporate inflation protection into its investments.

The vast majority of GCP’s portfolio is made up of loans. Of these around 60% by value are loans secured against renewable energy assets.

As a result the trust is well positioned to benefit from the UK’s 2050 net zero target which the UK Government’s independent adviser on climate change estimates will require £50 billion of annual investment by 2030.

QuotedData investment companies analyst Jayna Rana notes the trust has provided investors with ‘a high and stable’ stream of quarterly distributions since its launch in 2010.

She adds: ‘While GCP had to reduce its dividend last year, the current pipeline of investment opportunities may eventually enable the trust to reinvest capital and to support modest potential dividend growth going forward.’

GCP is targeting 7p in dividends for the financial year ending 30 September 2021, implying a 6.6% yield. [TS]

 

HENDERSON DIVERSIFIED INCOME (HDIV) £47.48

Five-year average yield: 5.1%

Great for bond exposure

This £167 million investment trust has is managed by veteran manager John Pattullo and Jenna Barnard and offers a unique investment approach focused on lending to large, quality businesses which makes the portfolio and dividend yield more durable through bad times as well as good.

Dividends are paid quarterly, and the trust has an ongoing annual fee of 0.93% a year, paid quarterly in arrears.

The trust has a good track record of outperforming its benchmark and has delivered a three-year annualised total return in net asset value of 7.9% a year compared with 3.4% for the benchmark according to Morningstar. The trust trades at a 4.9% discount to net asset value.

The managers adopt a flexible investment approach in meeting their investment objective of achieving a high income while preserving capital.

This means the managers have the freedom to actively allocate to different types of bonds and loans on a global basis depending on what they find attractive given their views on future interest rates and the economic cycle.

Just over 60% of the portfolio is invested in high yield bonds and a third in investment grade while the remainder is invested in secured loans. [MGam]

 

MERCHANTS TRUST (MRCH) 538p

Five-year average dividend yield: 5.3%

Income from UK large caps 

When it comes to security of income investors will struggle to beat Merchants Trust (MRCH). It is one of the so-called ‘Dividend Hero’ trusts to have raised their annual dividend each year for at least 20 years.

It is in rare company – only 18 trusts can demonstrate this long-run unbroken commitment to income, according to AIC data, and just five yield 5%-plus; Aberdeen Standard Equity Income (ASEI), Value and Indexed Property Income (VIP), Brunner (BUT) and Alliance Trust (ATST) are the others, all supported by the investment trust structure which allows money to be placed in reserves in good years to support dividends in tougher times.

Merchants, run by Allianz Global Investors’ Simon Gergel, seeks out well-positioned businesses that can continue to generate cash and pay dividends into the future, not simply buying lowly priced, high yielding shares today.

This has delivered superior returns over the years, with Merchants’ share price generating 9.7% annualised total returns over the past 10 years versus 8% from the FTSE All-Share says Morningstar. Most of the portfolio is in large cap UK stocks, with drugs firm GlaxoSmithKline (GSK) and defence group BAE Systems (BA.) among its biggest stakes while tobacco, financials and energy are also prominent. [SF]

 

SHIRES INCOME (SHRS) 277.5p

Five year average dividend yield: 5.4%

Differentiated strategy which includes buying preference 

and overseas shares

Shires Income (SHRS) seeks to deliver a high level of income together with potential for growth of both income and capital. The Aberdeen Standard Investments-managed trust looks well positioned to profit from post-pandemic dividend recovery given its bias towards financials.

The trust’s appealing 5.4% five year average yield and sustainable income stream stems from a diversified portfolio of good quality UK-listed companies combined with preference shares that delivered reliable income during the Covid crisis, not to mention convertibles and other fixed income securities with above-average yields; Shires also generates premium income by writing call and put options on various shares.

In a testing financial year to March 2021, the Iain Pyle-managed trust outperformed the benchmark FTSE All Share’s 26.7% return with a net asset value total return of 34% and a share price total return of 31.2%. And despite the impact of the pandemic on dividends,

Shires maintained a flat total dividend of 13.2p thanks to its significant revenue reserves. At last count, the biggest equity holdings included Aberdeen Smaller Companies Income Trust (ASCI), which provides Shires with UK small cap exposure, as well as AstraZeneca (AZN), Diageo (DGE), British American Tobacco (BATS) and Prudential (PRU); the fixed income book was populated by paper issued by Ecclesiastical Insurance, Santander, Standard Chartered and RSA.

Another interesting equity position is private equity firm Bridgepoint (BPT), bought at IPO for its ‘quality management team and good client relationships which sets them up well to continue their strong track record’. [JC]

 

TWENTYFOUR SELECT MONTHLY INCOME FUND (SMIF)  96.6p

Five year average dividend yield: 7.2%

Monthly income option

TwentyFour Select Monthly Income Fund (SMIF) has delivered a five year average yield of 7.2% according to SharePad, by investing in a diversified portfolio of fixed income credit securities.

Numis analyst Andrew Rees points out the fund not only pays a regular monthly dividend of 0.5p, but also a larger dividend in October to distribute the remainder of the financial year’s income. Rees says the historic yield is currently 6.3% and ‘this has proven resilient in times of stress’.

Currently trading at a modest premium to net asset value, Rees says TwentyFour Select Monthly Income aims to take advantage of the premium returns available from less liquid instruments across the debt spectrum, which are unsuitable for open-ended funds and provide the scope to benefit from an ‘illiquidity premium’.

He points out the portfolio is currently focused on debt issued by banks and asset-backed securities, as well as some high yield bonds.

Manager TwentyFour Asset Management continues to find attractive, high-yielding investment opportunities and Rees also highlights the quarterly redemption facility of up to 20% of the shares at a 2% discount to NAV, which ‘limits the discount and provides liquidity, making the fund more accessible than the (£184 million)market cap might imply’. [JC]

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