Income investors beware: dividends are set for the chop

Investors who rely on dividends for income will have been receiving bad news in the last couple of weeks. As companies struggle to conserve cash to see them through the coronavirus crisis, many have suspended future dividends. Some have even taken the drastic step of cancelling dividends that had already been declared.

Most significantly, banks such as Barclays, HSBC, Lloyds and RBS agreed this week to scrap around £15bn in dividends until at least the end of this year in order to preserve capital and bolster their ability to lend to struggling individuals and businesses. Financial stocks account for around 25% of the FTSE UK Equity Income index, while other major contributors include miners (15%) and oil and gas (8%), where payouts could be vulnerable as a result of drastic falls in commodity prices. Many steadier business will also be badly affected by the shutdown of the economy. So it seems certain that UK dividends will fall by far more than they did during the global financial crisis, when they were about 13% lower in both 2009 and 2010 than in 2008.

Three steps to manage your dividends

A crisis like this shows why building an income portfolio isn’t just about getting the highest yield every year – it’s crucial to think about how you can reduce the damage when yields get cut. Part of the answer is to include steadier firms – just because the index is heavily weighted in cyclical stocks, you don’t need to be. While few firms are entirely safe at a time like this, you’d expect payouts at utilities to hold up better. Profits at consumer staples and healthcare businesses are also likely to be less affected than most, although they may still take a more cautious approach to dividends than normal.

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Since the pound tends to weaken in a global crisis, holding international firms as well as UK ones can help. A weaker exchange rate will support the sterling value of dividends even if companies are also cutting payouts in local terms.

But investors can also learn from investment trusts that keep part of each year’s income in reserve and draw on it to maintain payouts in tougher times (see page 22). Putting aside 5%-10% of your dividend income over the previous few years (depending when you started) would have built up enough of a reserve to cover the shortfall during the financial crisis. There is a trade-off: holding a reserve means having cash sitting around unspent and earning little interest. However, having the coronavirus crisis and the financial crisis a decade apart, plus more modest falls in dividends around the dotcom bubble and in the early 1990s, remind us that it’s prudent to plan for disruption at least once a decade.

I wish I knew what a dividend yield was, but I’m too embarrassed to ask

A dividend yield is simply a company’s total annual dividend per share – the amount of money it has paid or will pay to shareholders in a year – divided by its current share price and expressed as a percentage. For example, if a company paid a single dividend of 10p per share this year and its shares are trading at a price of 1,000p, the dividend yield would be 10p ÷ 1,000p = 0.01 (which is 1%). If the firm paid a dividend of 5p after half a year (usually called an interim dividend) and a further 10p at the end of the financial year (a final dividend), you would add the two together and get (5p + 10p) ÷ 1,000p = 0.015 (1.5%).

Dividends are not fixed: a company may vary its dividend according to how profitable the past year has been, whether it needs to hold on to more of its profits to invest in maintaining or growing its business, or whether it has more cash than it needs and wants to make an extra one-off payment to shareholders (often called a special dividend). So we need to take this into account. To get a more complete picture, the dividend yield can be calculated based on what the firm paid in the past 12 months or calendar year (sometimes referred to as the trailing or historical dividend yield) or on the amount that it’s expected to pay over the next 12 months (a forecast or forward dividend yield). Trailing yields reflect what has actually been paid – but past dividends may not be sustainable. Forecast yields reflect any changes that analysts expect – but forecasts are unreliable.

Investors should look at both, but should not rely solely on either to make their decision: you need to think about the long-term prospects for a firm’s dividends, including any signals that the market is sending. A firm with a very high yield may look cheap, but this could indicate that investors expect the dividend to be cut. Meanwhile, a firm with a lower yield might be expected to grow it rapidly in the years ahead.