How reliable is your income from dividend payouts?

Many blue-chip stocks are stretching their dividend payouts to the limit. Make sure you don’t pay the price.

BP oil workers © BP

Investors are probably sick of hearing about equity income funds in the wake of the Neil Woodford debacle. But this week attention has turned to traditional equity income funds, rather than Woodford's (which wasn't really an equity income fund at all). The general point (and appeal) of an equity income fund is that it invests in companies that offer higher-than-average dividend yields, whereas Woodford's fund eventually owned large numbers of unlisted stocks paying no dividends at all, propped up by a few mid-cap high-yielders.

The good news is that most UK equity income funds you're likely to own are nothing like that. The bad news, as Laura Suter of investment platform AJ Bell pointed out this week, is that many funds are currently invested in stocks that appear to be pushing the limit when it comes to their payouts.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Dividend cover is a simple ratio that compares earnings with dividend payouts. Ideally, you'd want to see a dividend cover of twice or more in other words, where earnings are at least twice as large as dividend payouts, providing a nice cushion in case of future disappointments. However, dividend cover across the board has been steadily shrinking and is expected to hit its lowest level in a decade this year. The risk is that this will leave companies unable to maintain their payouts.

As Suter flags up, ten of the highest-yielding stocks in the FTSE 100 have dividend cover of less than 1.5. These include housebuilders Persimmon and Taylor Wimpey and tobacco giant Imperial Brands (all of which trade on extraordinarily high yields of above 11%), while both of the oil majors, BP and Shell (yielding a bit below 7% a piece), are also on the list. In turn, says Suter, of the 83 funds in the UK Equity Income sector, a full 30 of them own five or more of these high-yielding "dangerzone" stocks in their top-ten holdings. Some of the biggest funds on the list include the Man GLG UK Income fund and the M&G Dividend fund.

Advertisement
Advertisement - Article continues below

Does low dividend cover mean a stock is heading for a dividend cut? Not necessarily. Companies with dependable earnings can operate with lower dividend cover than those with volatile earnings. And with dividend yields above 11%, a fund manager may consider a stock worth buying in any case even if the dividend is trimmed, it may still end up being reasonably generous. However, if you are an income investor, look at the funds you own (and any individual stocks you have) to check just how dependent your income is on individual stocks. If your payouts are coming from just a handful of companies, you may want to diversify your portfolio further.

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

Duration (the value of which can be found in the fact sheet of most bond funds) tells you the expected percentage change in a bond's price in response to a one percentage point (100 basis points) change in interest rates. The higher the duration, the higher the bond's "interest-rate risk" that is, the larger the change in price for any given change in rates. This is also known as "modified" duration.

Duration can also refer to the weighted average length of time (in years) it will take to recoup the price paid for a bond in the form of income from its coupons (interest payments) and the return of the original capital. So if a bond has a duration of ten years, that means you have to hold it for ten years to recoup the original purchase price (this is also known as "Macaulay" duration).

In practice, both measures of duration return very similar values. So in the above example, the duration value of ten also indicates that a single percentage point rise in interest rates would cause the bond price to fall by 10%.

As a rough guide, the duration of a bond increases along with its maturity so the longer a bond has to go until it repays its face value, the longer its duration. Also, the lower the yield on the bond, the higher its duration the longer it takes for you to get paid back.

All else being equal, a high-duration bond is riskier (more volatile) than a low-duration bond. For zero-coupon bonds (bonds that don't pay any income at all), the duration is always the remaining time to the bond's maturity. For interest-paying bonds, duration will always be less than its maturity (albeit often slightly).

Advertisement

Recommended

Visit/504054/the-power-of-mean-reversion
Funds

The power of mean reversion

When it comes to investing in funds, don’t chase the top performers – look for the cheapest ones.
1 Apr 2019
Visit/503809/investing-in-funds-the-most-important-number-to-look-at-before-you-buy
Funds

The most important number to look at before you buy any fund

Many investors get distracted by past performance when they buy a fund. But there’s something else to consider that will have a much bigger influence …
22 Mar 2019
Visit/investments/investment-strategy/investment-gurus/600703/martin-gilbert-most-assets-still-look
Investment gurus

Martin Gilbert: most assets still look “reasonable” value

Only government bonds seem too expensive, says Martin Gilbert, vice chairman of Standard Life Aberdeen.
24 Jan 2020
Visit/investments/investment-strategy/600702/emerging-markets
Investment strategy

Emerging markets

An emerging market is an economy that is becoming wealthier and more advanced, but is not yet classed as "developed".
24 Jan 2020

Most Popular

Visit/investments/commodities/gold/600686/gold-and-silver-bull-market-2020
Gold

Want to make money in 2020? Gold and silver are looking like a good bet

If you want to make money from investing, says Dominic Frisby, it’s simple: find a bull market and go long. And in 2020 gold and silver are in a bull …
22 Jan 2020
Visit/investments/stocks-and-shares/share-tips/600672/share-tips-of-the-week
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
24 Jan 2020
Visit/economy/global-economy/600711/the-charts-that-matter-coronavirus-or-a-liquidity-air-pocket
Global Economy

The charts that matter: coronavirus – or a liquidity air pocket?

With the yield curve showing worrying signs of flatlining again. John Stepek wonders what's to blame and turns to the charts that matter most to the g…
25 Jan 2020
Visit/investments/investment-strategy/600709/the-coronavirus-is-scary-but-its-irrelevant-to-your
Investment strategy

The coronavirus is scary – but it's irrelevant to your investments

The spread of the coronavirus is causing alarm around the world. And, while it could be a serious short-term threat to human health, it’s not somethin…
24 Jan 2020