The Income Investor: rate cuts will boost these dividend shares

Income investors may have mixed emotions when it comes to the prospect of interest rate cuts. On one hand, the Bank of England’s decision to hold rates at a 16-year high of 5.25% earlier this month means the income return on their cash balances remains attractive. But, on the other hand, their shareholdings may fail to produce meaningful dividend growth as companies struggle to raise profits amid a tough economic environment.

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Irrespective of how income investors feel about changes to Bank Rate, of course, interest rate cuts are extremely likely to begin this year. The Bank of England’s latest Monetary Policy Report now anticipates inflation will be stickier than previously expected, and may take up to three years to consistently meet its 2% target, but a weak economy and the existence of time lags mean interest rates are currently tipped to fall to 3.9% within the next 12 months.

The appeal of dividend stocks

The UK economy contracted by 0.1% in the third quarter of 2023. It would be unsurprising if it did experience another quarter of negative growth that equates to a technical recession, as the impact of previous interest rate rises, for example on mortgage renewals, gradually filters through. This may prompt the Bank of England to adopt a more dovish stance before inflation meets its 2% target, with any changes to monetary policy likely to take at least six to 12 months to fully impact the GDP growth.

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All this means that dividend stocks are likely to become increasingly attractive for income-seeking investors. At the same time as cash balances produce a lower level of income amid interest rate cuts, dividend growth rates are likely to be positively catalysed by monetary policy stimulus that boosts the UK’s economic growth rate.

And while bond prices should, in theory, rise as interest rates fall, the fixed nature of their income and the fact they are redeemed at par means dividend shares offer scope for higher returns over the long run.

A changing income investing landscape

Of course, the yields currently on offer from dividend stocks are not particularly attractive relative to other mainstream assets. The FTSE 100 and FTSE 250 indexes, for example, both yield 3.9%. This is lower than the 5.2% interest rate offered on easy access savings accounts. It is also slightly behind the 4% yield on 10-year gilts and significantly less appealing than the 6.9% income return available on global high-yield bonds.

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However, a period of sustained interest rate cuts that boost dividends is likely to turn those rankings on their head. An initial 3.9% yield on a dividend stock will, for example, rise to 5% within five years if dividends grow by 5% per year amid improving operating conditions. And with bond yields and interest rates on cash balances set to fall, shares should become the asset class of choice for income-seeking investors.

Heightened volatility

Between now and then, dividend shares are likely to exhibit significant volatility. Many investors seem to be fixated on predicting exactly when interest rates will fall and specifically how quickly, or slowly, the UK economy will expand in the short run. This will inevitably lead to a constant flip-flopping between periods of optimism and pessimism that prompts significant share price fluctuations as economic data remains wholly unpredictable.

Ultimately, though, an improved economic landscape prompted by lower inflation and interest rate cuts means dividend shares are set to provide a highly attractive income return over the coming years. Allocating a larger proportion of an income portfolio to them is therefore likely to be a sound long-term move.

Source: Refinitiv as at 9 February 2024. Bond yields are distribution yields of selected Royal London active bond funds (31 December 2023), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 8 February. LIBOR is interest rate that banks lend money to one another (3 month GBP LIBOR as at 9 February). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 9 February.

Retail opportunity

UK-focused retailer Pets at Home Group (LSE:PETS) offers income investing appeal despite continuing to struggle amid a weak operating environment. The company, which sells pet-related products and provides veterinary services, issued a profit warning in its third-quarter trading update last month. It now expects pre-tax profits for the full year to amount to £132 million versus previous guidance of £136 million.

Tough trading conditions were to blame for the downgrade in profit expectations, with demand for discretionary pet accessories being particularly soft. Crucially, though, the company was able to increase market share within the pet food segment and continued to generate strong growth in its vet group, where sales rose by 13.4%. It also delivered an improvement in gross margin versus the first half of the financial year.

Therefore, the firm is in a strong position relative to its sector peers and is ready to capitalise on improving trading conditions as interest rate cuts stimulate the economy. Its net gearing ratio of 39% and interest cover of around six in the first half of the financial year, mean it is also well placed to overcome short-term challenges.

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From an income perspective, the company’s dividend yield of 4.5% may not seem all that appealing at first glance. However, it was covered a healthy 1.8 times by earnings per share last year and has grown at an annualised rate of 11% over the past five years. With the company’s operating environment set to improve, and it investing in new brands as well as launching a new digital platform to strengthen its market position, it offers attractive dividend growth potential.

Consumers are already beginning to experience improved spending power as inflation falls, with total pay having risen at a positive real rate since April 2023. While Pets at Home is by no means a defensive income stock and faces an uncertain near-term outlook, its long-term risk/reward opportunity is favourable.

Property potential

Likewise, Land Securities Group (LSE:LAND) offers long-term income investing appeal. The UK-focused real estate investment trust (REIT), which owns offices in central London alongside retail and mixed-use developments elsewhere, currently yields 5.9% after its share price fall of 7% since the start of the year.

Higher interest rates have negatively affected property values, with the company’s net asset value (NAV) per share falling by 4.9% in the first half of its current financial year. This means it now trades on a price-to-book ratio of just 0.7, which suggests it has a wide margin of safety and that investors have factored in the potential for further property price declines.

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The firm is in a strong position to take advantage of impending interest rate cuts. It previously sold £1.4 billion of single-let offices in London, which equates to around 14% of its current portfolio, at prices higher than current market values. Alongside a solid financial position that includes a modest loan to value (LTV) ratio of 34% and a weighted average debt maturity of nine years, this means it is well placed to capitalise on temporarily low property valuations ahead of an improving outlook for the sector.

As with Pets at Home, Land Securities faces an uncertain near-term outlook. Both companies’ reliance on the UK economy at a time when its prospects are challenging could dissuade income investors from buying them. But with solid financial positions and the prospect of dividend growth as interest rates fall, they offer attractive income investing potential over the long term.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.