The big dividend question

UK stocks are paying higher dividend yields than at any point since the financial crisis. Should you buy in?

There are lots of reasons to be nervy about investing in the UK right now. The ever-shifting nature of Brexit is one issue; the potential for a Jeremy Corbyn government and the policies that might accompany it are another not entirely unconnected factor. But there's an argument to suggest that a lot of this uncertainty is being priced in just now.

The overall dividend yield on the FTSE All-Share index, at around 4.5%, is now floating around its highest level since the financial crisis. The big question, of course, is will these dividends be paid?One measure to look at is dividend cover (see below). Cover for FTSE 100 stocks has improved in recent years, notes Laurence Fletcher in the Financial Times, but it's "still well below its long-term average".

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FTSE 100 companies currently pay out an average of 58% of income versus the long-term average of 50%. But while there's no doubt that some stocks are at risk of cuts (phone group Dixons Carphone cut its dividend by 40% this week, for example), it's hard not to be tempted at this level, particularly as high, or at least decent, yields are not limited to any one sector.

Should you feel confident enough, you can go for individual stocks. For those who have no desire to stock pick, there are plenty of funds to look at. On the passive side, you could buy a FTSE index tracker or exchange-traded fund (ETF) with very low fees.

If you want a tracker, the HSBC FTSE All-Share fund charges 0.04% while the iShares Core FTSE 100 ETF (LSE: ISF/CUKX) the former ticker pays out dividends, the latter reinvests them has an ongoing charge of just 0.07%. Both yield more than 4%.

Other options to consider are passive strategies that focus purely on dividends. The SPDR UK Dividend Aristocrats (LSE: UKDV) focuses on the 40 highest-yielding UK stocks that have raised or held their dividend for at least seven years in a row.

Top holdings include telecoms group BT and retailer Marks & Spencer. It yields 4.6%.The iShares UK Dividend (LSE: IUKD) follows the FTSE UK Dividend+ index, which tracks the highest-yielding 50 stocks in the FTSE 350, and yields 6.6% (which does hint at the risk that some of those holdings may not pay up). The Vanguard FTSE UK Equity Income fund tracks the FTSE UK Equity Income index. It avoids holding more than 25% of its value in one sector and currently yields around 5.7%.

On the active side, investment trusts offering high yields include the Henderson High Income trust (LSE: HHI) on 5.9% and Dunedin Income Growth (LSE: DIG) on 5.6%. Both invest mainly in UK-listed blue chips. Another interesting option is Shires Income (LSE: SHRS), which owns several preference shares and yields 5.6%.

I wish I knew what dividend cover was, but I'm too embarrassed to ask

Companies pay dividends to shareholders out of their profits. A dividend is entirely discretionary unlike the interest payment on a bond, it doesn't have to be paid and it can be cut or even scrapped altogether if deemed necessary. Directors decide what proportion of profits they will distribute: the amount varies depending on how well the company has done (ie, on how much the directors feel it can afford to pay out), but also on other, less tangible, factors.

For example, directors tend not to be keen on cutting dividends because the market reaction is typically bad. Also, fast-growing firms tend to pay out a lower percentage of their profits than more mature firms, because they prefer to invest all or most of their profits in opportunities for future growth.

If a company's dividend yield (the dividend per share expressed as a percentageof the share price) looks particularly high, then that can be a warning sign. For example, if a company is paying a dividend of 10p a share, and the share price is £1, that's a yield of 10%. If the average for the index or sector is much lower than that, then it suggests investors are highly sceptical that the dividend will end up being paid.

So when assessing the financial health of a company, it's worth looking at dividend cover as a guide of how likely it is that the dividend will remain stable or rise in the future. Dividend cover simply measures how many times over the dividend payout is covered by the profits available to pay for it.

To take a very simple example: a firm that makes £20m in profit and allocates £2m for dividends has a cover of ten, while a firm that makes £50m but pays out £25m in dividends has a cover of two. The higher the dividend cover is, the more sustainable the payout. The "payout ratio" is simple the inverse of the dividend cover ratio so in this example, the first company has a payout ratio of 10%, while the second is on 50%.