How reliable is your income from dividend payouts?

BP oil workers © BP
BP: nice dividend, but is it reliable?

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

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.

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.

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” is a measure of risk that usually relates to bonds. It describes how sensitive a given bond is to movements in interest rates. Think of the relationship between bond prices and interest rates as being like a seesaw: when one side (interest rates) goes up, the other (in this case, bond prices) goes down.

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).