Don’t be tempted by cash savings – this trust offers a far superior outlook for income investors

Rapidly rising interest rates are tempting some income investors to hold cash rather than dividend shares. After all, easy-access savings accounts now offer rates of 3pc. Individuals willing to lock up their capital for a year or more can easily obtain an interest rate in excess of 4pc.

Both figures are likely to rise before they decline. The Bank of England is widely expected to persist with a hawkish monetary policy over the coming months as it grapples with double-digit annual inflation. And with the economy technically not yet in recession, it has scope to raise rates to the benefit of savers.

At the same time, the FTSE All-Share index yields just 3.4pc. When the added risks of holding shares are taken into account, especially while the economy’s near-term prospects are highly uncertain, it is unsurprising that cash is proving to be somewhat alluring to income investors.

In Questor’s view, however, investors should avoid pivoting from dividend stocks to cash in the hope of generating a higher return. Although cash may offer a higher income return today, terminal Bank Rate could prove to be lower than many investors anticipate. After all, a rapidly slowing economy amid fast-paced interest rate rises is likely to have a hugely downward impact on the annual inflation rate.

The Bank of England expects it to fall to just 3pc within the next year, which means today’s cash returns may be close to their peak.

Conversely, income shares offer significant scope for dividend growth. The economy’s almost inevitable recovery from its present slump is likely to prompt growing earnings and higher shareholder payouts. When combined with the prospect of capital returns in a rising stock market, total returns from income stocks could vastly outweigh those of any easy-access or fixed-rate savings account.

Investment trusts such as Lowland Investment Company, which has been a holding in this column’s income portfolio since April 2019, continue to be an excellent means of generating a relatively high yield today while offering the potential for inflation-beating dividend growth in future years. The trust’s 4.8pc yield represents a far more competitive income return than that of the FTSE All-Share index – its benchmark.

More importantly, the company’s dividends have been extremely reliable, having been maintained or increased in every year since it was founded in 1963.

Over the past three decades, they have risen at an annualised rate of 6.8pc on a per share basis. While this is lower than the current annual rate of inflation, which stands at 10.1pc, it is likely to far exceed the rate of price rises over the long run. In fact, according to the Bank of England’s inflation calculator, inflation averaged just 2.2pc per year between 1992 and 2022.

Clearly, inflation-beating dividend growth is never guaranteed. Although the current downturn is unlikely to last forever, estimating when a recovery that prompts higher earnings and growing shareholder payouts will take place is not an exact science.

Moreover, the trust’s bias towards smaller companies relative to the FTSE All-Share index means that its short-term performance could prove to be somewhat muted compared with funds that are weighted towards large-cap stocks.

Indeed, this is a key reason why its shares have fallen by roughly 5pc since being added to Questor’s income portfolio nearly four years ago. Large-cap shares may retain their present favour among risk-averse investors while the economy’s outlook is downbeat, with the trust’s 8pc discount to net asset value highlighting its relative unpopularity.

Of course, many of its largest holdings are global businesses such as Shell, Anglo American and GSK that are set to benefit from the world’s upbeat long-term growth potential.

But the trust’s real appeal lies in its holdings of vastly undervalued mid and small-cap stocks that offer compelling capital return potential alongside strong dividend growth as the UK economy ultimately recovers.

The company’s gearing ratio of about 12pc will further enhance capital gains as investor sentiment towards the riskier peripheries of the stock market gradually improves.

Overall, the trust continues to offer a favourable long-term opportunity for income investors. Its yield may lack obvious appeal relative to cash in the short run, but its long history of dividend growth, the prospect of an economic recovery and a wide discount to net asset value highlight its capacity to deliver high returns over the coming years. Hold.

Questor says: hold

Ticker: LWI

Share price at close: 127.5p

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