What investors need to know about the return of dividends

In investment terms, dividends payouts were among the biggest casualties of the Covid-19 pandemic. Companies slashed their payouts back to 2017 levels on a global basis, according to data from fund manager Janus Henderson, with the UK market being hit particularly hard.

And yet what could have been a nightmare for dividend-dependent investors has turned out to be far less damaging than feared. According to the fund group’s latest global dividend index, payouts will recover pre-Covid-19 highs within a year.

What happened? Unheard-of government support for businesses and employees, combined with a surge in demand as restrictions eased, meant that companies found they had been overly pessimistic.

Banks reversed bad debt provisions, while firms across the board found that their main problem was meeting customer demand rather than managing a  decline.

Yet there are a few useful lessons that dividend-focused investors should learn from this near-miss. Firstly, UK investors should note that while payouts are recovering fast, UK dividends may not get back to 2019 levels before 2025. Companies have taken “the opportunity to reset payments at more sustainable leves”, Helen Bradshaw of Quilter Investors tells the Financial Times, as payout ratios (see below) were stretched in several sectors even before Covid-19 struck.

Oil major Shell’s chief executive Ben van Beurden is upfront about it: “We felt that our dividend needed to be reset... the gap between our dividend payout and free cash flow was simply too large.”

This is good news – it implies that if you’re buying UK stocks just now, then dividend payouts should be on a more sustainable footing than they have been in some time. On the other hand, it shows the importance of diversifying. The FTSE 100 index is a high-yield index, but there is more to dividends than yields.

Growth matters too. So it’s even worth looking at regions that may seem to have less recovery potential – Japanese stocks barely cut dividends in 2020 yet saw “strong” 11.9% underlying growth in the past year.

But the most important lesson is this: don’t get too hung up on dividend income. Yes, dividends are great – they remind managers of who they’re working for (shareholders) and they’re a transparent way to return cash.

However, if you are at the stage of your investment life where you are relying on your portfolio for regular income rather than building a nest-egg, then dividends should only form one part of that strategy.

Other income-generating assets such as property and bonds are key, while ensuring you always have a cash cushion of one or two years’ living expenses will help to ensure you aren’t forced into cashing in investments at exactly the wrong moment.