UK equity income funds have long been a default option for dividend investors, and with good reason. Thanks to an established dividend culture, the UK market is home to a plethora of high-yielding companies, making it a natural choice for those looking for income-producing investments. 

However, selecting the best income-focused fund for your portfolio is not always straightforward. Prioritising high yield in the short term can come at the expense of continuous dividend growth over time. Additionally, while capital growth may not be a priority for income investors, you do not want to select a trust that neglects it entirely. 

Schroder Income Growth (SCF) strikes a sensible balance between these factors, making it a solid option if you are looking to add a UK-focused income fund to your portfolio.

A style-neutral barbell approach 

The trust has two main ambitions: to deliver income growth in excess of the rate of inflation, and capital growth derived from rising income. To achieve this, it adopts a barbell approach to portfolio construction, prioritising neither growth nor value companies in its portfolio, instead selecting a mix of both. 

“We will have some high-yield companies where we feel that the dividend is secure,” says Sue Noffke, Schroders’ head of UK equities and the manager of Schroder Income Growth. “We will also have some growing dividend companies, and those that have an average yield within the market but where we think growth could be stronger,” she adds. 

Currently, the trust has 46 holdings, and its top 10 is dominated by UK heavyweights such as AstraZeneca (AZN), HSBC (HSBA) and Lloyds Banking Group (LLOY). It is notably overweight to financials, healthcare and consumer discretionary stocks. 

While the UK economy has clearly faced challenges of late, Noffke argues that this presents an opportunity for income investors, particularly as a high percentage of UK companies’ revenue is derived elsewhere. 

“The attraction of the UK is that you get international earnings at a discount valuation,” she says. “Revenues from the UK market are somewhere between 75 and 85 per cent derived from outside the UK, so the UK equity market is not fully representative of the UK economy.” 

The trust also has a notable focus on small and mid-cap companies, despite this sub-segment falling notably out of favour in recent years. “We think there is a medium- to longer-term opportunity there because there are a lot of growth companies and the dividend yield available is higher than [for] the FTSE 100, and they are participating to a greater degree in the capital return story through share buybacks,” Noffke says.

This could leave the trust well positioned if UK small and mid-caps were to witness a recovery. “Given current mid-cap valuations, and their dividend growth and earnings recovery potential, the trust’s overweight exposure offers meaningful upside if sentiment improves, while also supporting the portfolio’s underlying income potential,” says Josef Licsauer, an investment trust research analyst at Kepler Partners.

On the whole, the trust’s strategy has paid off, and it usually outpaces its industry peers. Over the past financial year, however, it lagged the FTSE All-Share, generating a total return in net asset value (NAV) of 9.6 per cent, compared with 12.6 per cent for the index. Noffke attributes this to the companies the trust didn’t hold, rather than the underperformance of those that it did. She cites the absence of Rolls-Royce (RR.) and being underweight other top performers in the defence and aerospace sector as a key detractor. 

The trust remains committed to its strategy, as well as its belief in the long-term growth prospects of, and the higher dividend yields provided by, UK small and mid-cap businesses. 

Budget headwinds 

Of course, it is difficult to talk about investing in the UK at the moment without considering the recent Autumn Budget, which has been widely criticised for failing to address the UK economy’s lack of growth. 

Noffke believes that while the Budget was not overwhelmingly positive for UK businesses, it was “good enough”, both in terms of placating Labour backbenchers – and, therefore, delivering a degree of political stability – and because it did not spook the gilt market, allowing UK assets some breathing space in which to perform. 

Inevitably, there will be some winners and losers. The fact that the banking sector escaped relatively unscathed will be a boost for the portfolio, given its higher weighting to financials (35.7 per cent, versus the benchmark’s 28.3 per cent).

However, there was little relief for the hospitality and retail sectors, which are still struggling following emploer national insurance and minimum wage increases.

Proposed business rate reforms will probably prove to be a mixed bag. The lower business rates on offer for smaller businesses will be welcomed, but this is being funded by higher rates for companies with more expensive properties. The trust’s relatively limited exposure to these sectors could therefore prove to be a positive in the coming months. 

A dividend hero 

At 4.4 per cent, the trust’s dividend yield is marginally higher than the AIC UK Equity Income sector average of 4 per cent. What sets Schroder Income Growth apart, though, is its status as an AIC dividend ‘hero’. This accolade has been earned by achieving consistent dividend growth for the past 30 years. 

Over the past financial year, the trust’s dividend growth was 3.5 per cent – an impressive achievement during a year when the UK faced both unfavourable exchange rates and a move towards share buybacks, Licsauer argues.

“Against that backdrop, the trust’s growth in both earnings and dividend is encouraging, underpinned by its broad income sources, exposure to businesses buying back shares sustainably and the board’s supportive reserve policy,” he says. 

In addition, shareholders now benefit from a policy of smoothed dividend distribution, instituted by the trust’s board in 2025. This is particularly helpful for investors looking for consistent income. The trust distributes its dividend on a quarterly basis. Under the new policy, shareholders are able to receive a larger proportion of the yearly dividend during the first three payments than previously. 

Over the past year, the board has also taken other steps to keep shareholders happy and enhance returns. These include reducing the trust’s management fee from 0.45 per cent to 0.4 per cent. In addition, fees for company secretarial and administration services have been removed.

The trust’s board has also introduced a discount control policy targeting a single-digit discount in order to reduce volatility for shareholders, and this policy is paying off. Currently, the trust is trading at a 6.9 per cent discount, placing it in the top spot in recent Stifel analysis of the investment trusts trading at the narrowest discounts compared with their six-month averages.  

Yet Mick Gilligan, head of managed portfolio services at Killik & Co, warns that investors should still keep in mind that the fees for the trust remain relatively high. “This is largely a function of the trust’s size. At a £227mn market cap, it ranks 13th out of 18 in the AIC UK Equity Income sector,” he says. “At this size, fixed costs have a larger impact, and below-average liquidity is reflected in a wider than average bid-offer spread.” 

The ‘big six’ banks – Barclays (BARC), HSBC (HSBA), Lloyds (LLOY), Nationwide (NBS), NatWest (NWG) and Santander (BNC) – might provide 74 per cent of all mortgages in the UK, but in its field OSB Group (OSB) punches well above its weight.

The FTSE 250-listed company is the UK’s largest independent specialist buy-to-let (BTL) lender – a market where the big six have relinquished control, managing just over half of these mortgages. 

While under-investment meant OSB failed to re-price assets quickly enough as interest rates rose, leading to a derating and a string of profit warnings in 2023-24, the bank is now three years into a five-year transformation programme and has put the worst behind it.

As a result, the shares have been on an upswing, rising by two-fifths over the past 12 months. Yet at just 7.5 times forward earnings, for the patient investor the value opportunity remains.

BTL lending makes up 70 per cent of OSB’s loan book, and with the Renters’ Rights Act expected to increase the regulatory burden on landlords when it comes into force next year, OSB’s reliance on the BTL mortgage market could pose a revenue concentration risk.

OSB’s medium-term targets – which include reducing BTL lending to less than 60 per cent of its total loan book – prove a tacit acknowledgment of this. However, BTL will ultimately continue to make up the majority of OSB’s loan book through to 2029. It is therefore worth understanding why the bank seems happy to keep it.

Much of the BTL loan book’s appeal comes from the fact that it specifically serves ‘professional’ landlords, whose multi-property portfolios better place them to withstand rising costs and regulation. As navigating such challenges for just one property grows increasingly unappealing, more ‘amateur’ landlords will exit the market, placing upward pressure on rents. From this, professional landlords stand to gain.

Panmure Liberum analyst Ross Luckman says that, as a result, the “structural growth fundamentals remain robust” in the UK rental market. He estimates that OSB’s share of the BTL lending market will grow by 0.5 to 1 per cent per year.

Even so, it doesn’t hurt to diversify. OSB plans to do this by building on its existing underwriting expertise in higher-yielding areas, where risk-adjusted returns are higher. 

Over the medium term, OSB plans to dedicate more of its balance sheet to categories such as specialist residential mortgages, lending to those who are self-employed or part of a shared ownership scheme, and development and asset finance, where OSB lends to fund housebuilding by developers, or critical assets such as construction machinery for small businesses. OSB’s key differentiator is its ability to offer bespoke underwriting where the big six banks are not involved. 

A play on UK deregulation 

Deregulation in the banking sector is good news for OSB’s capital efficiency and cost of funding. As a smaller bank, the most important reforms for OSB relate to the ‘minimum requirement for own funds and eligible liabilities’ (MREL) legislation.

MREL currently applies to banks with total assets north of £15bn, and mandates that they hold enough equity and issue specific debt that can be written down should the firm fail. MREL reforms, effective from January 2026, propose raising the threshold at which the rules apply, based on indexed nominal GDP growth.

With total assets of £30.3bn, MREL is currently punitive for OSB. Like larger banks, it is required to maintain a capital buffer, but its lack of a current account base means OSB cannot mitigate the effects on its cost of funding as effectively.

Because the MREL rules have been in place since 2015, it’s possible that the length of the indexation period might produce a suggested threshold closer to £40bn by 2026. If so, OSB could drop out of MREL, paving the way for additional shareholder returns as surplus capital is unlocked.

Deutsche Bank analyst Robert Noble believes that this could add up to 2 percentage points to OSB’s return on tangible equity (ROTE). 

OSB is currently seeking clarification on its MREL status from the Bank of England, but Noble remains bullish in any case, viewing the prospect of deregulation as merely bonus upside.

“OSB’s standalone business with regulatory headwinds is worthy of investment on its own,” he says.

Why patience may be required

While OSB awaits news on deregulation, the bank is pressing ahead with internal transformation.

Its medium-term aspirations identify FY2025 and FY2026 as the ‘transition’ period, before earnings kick up a gear from FY2027 onwards, when ultra-low interest rate loans written in 2021-22 should mature and roll off the book.

Management has been explicit in its guidance that while the gradual replacement of lower net interest margin (NIM) business takes place, the market should expect a low-teens ROTE for FY2025-26, before progressing to a mid-teens ROTE over the medium term. For 2026, some modest earnings per share progression is expected from last year on account of OSB’s ongoing share buybacks. 

OSB has spent the past three years pursuing a transformation programme to address the legacy issues that pushed it into profit warning territory in 2023.

Much of this is ‘catch-up’ expenditure after years of underinvesting in its platform. This vulnerability was exposed after the base rate hikes of 2022, when intense competition for deposits saw OSB pass on rates to savers far more quickly than it did to borrowers, rapidly increasing the bank’s cost of funding, and leading to a severe compression in NIM – the difference between what it earns on loans and pays out on deposits. 

Now, things look different. OSB has upgraded the systems infrastructure around its deposit base and loan book, and with more than four-fifths of OSB’s funding coming from retail deposits, the changes will enable quicker re-pricing of its assets, to realise the benefits of rates coming down and lower the cost of funding.

“Lower rates are better for companies such as OSB and Paragon Banking Group (PAG), because lower rates make mortgages more affordable and make the assets they are lending against more valuable,” according to Indriatti van Hien, a fund manager at Janus Henderson.

The system upgrades should also reduce decision time for approvals on BTL loans. This will increase lending volumes, as well as improving customer service and therefore retention rates. 

OSB is a company that is nearing an inflection point as its transformation comes to fruition, lower NIM business rolls off and the rates environment turns favourable. In addition, the possibility of deregulation combined with efforts to diversify into higher-yielding products should mean that there is serious upside on offer for long-term investors.

Management is committed to shareholder returns, evidenced through its ongoing buyback programme, as well as a target to grow the dividend per share by 5 per cent even in its ‘transition’ period.

“For us, the attraction of OSB is the all-in yield it provides through its share buyback and dividend yield, on top of a growing loan book,” says van Hien. At its current valuation, OSB’s 6 per cent dividend yield looks enticing relative to its low price/earnings ratio.

With the shares on an upward trajectory, the key to another re-rating for OSB will be its ability to string together a consistent set of earnings over the next few quarters, even as long-standing chief executive Andy Golding retires next year.

If it delivers, this should rebuild some of the confidence that was lost in 2023. All else being equal, we are in agreement with the FactSet analyst consensus – OSB looks like a worthy buy.