Investors should proceed with caution when buying UK income stocks, as the high dividends they offer may be unsustainable, according to broker AJ Bell.
FTSE 100 companies are forecast to pay out £87.5bn in dividends in 2018, equating to a dividend yield of 4.4 per cent - far higher than the average return on cash savings and bonds. Dividend yield is a measure of a company’s income payments relative to its share price.
Several companies have experienced a rise in dividend yield mainly as the result of sharp share price falls, meaning they may struggle to pay their high income in future.
Companies such as Persimmon and Centrica are now sitting on forecast dividend yields of more than 9 per cent, signalling high potential income to investors.
But many of the top payers have seen increases in their yields not because their dividends have risen but because their share prices have fallen sharply.
Many of those stocks are not on track to generate enough revenue to cover their dividends more than two times over, which analysts cite as the ideal minimum level. This means that if those stocks run into trouble this year, investors could see their dividends cut too.
According to AJ Bell, earnings cover improved over the first quarter of 2018 but remains at an average of 1.71 times, meaning companies could not pay out their planned dividends more than 1.71 times from current earnings. At the end of 2017, cover had been even more precarious, at a level of 1.63 times.
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Income among the highest-yielding companies looks shakier still. Average dividend cover across the 10 highest yielding stocks in the FTSE is just 1.42 times.
AJ Bell said: “Dividends cover of around 1.5 is less than ideal because it means a company has less room for manoeuvre if profits fall in one year. It will then need to decide whether to reduce its dividend, stop reinvesting in the business or take on more debt.”
Centrica, currently forecast to yield 8.4 per cent in 2018, was trading at more than 220p in April 2017 but is now below 140p. Its dividend is only covered 1.19 times by its earnings.
Shares in Micro Focus, a technology company, also shed half their value in March. The company revealed that sales were falling and announced the departure of its chief executive Chris Hsu last month, just two years after a £6.6bn merger with Hewlett-Packard. The company is currently yielding 7.5 per cent.
AJ Bell said: “The 10 highest forecast dividend yields in the FTSE 100 this year are starting to look questionably high.”
Investment trusts with assets in UK equities have similar dividend cover ratios, but according to data from Numis, investors in these are better protected due to the pots of cash that such trusts hold in reserve.
The average UK equity income investment trust currently has dividend cover of 1.1 times and could cover dividends 0.7 times from their reserves.
Unlike mutual funds, investment trusts can hold back income each year to continue paying out dividends even if earnings fall. That means that they can cover their dividends each year both from earnings and revenue reserves.
Sam Murphy, analyst at Numis, said: “Investment trusts in the UK Equity income sector have been pretty prudent. Dividend cover on average is 1.1 so they’re all putting away income for a rainy day.”
Across the sector, the average trust has managed to see its dividends grow over the year by 5.6 per cent.
Trusts with the best protected dividends include Diverse Income Trust, whose holdings include Royal Dutch Shell and trading platform IG Group. The trust currently raised its dividend by more than 7 per cent between 2017 and 2018 and increased its revenues.
This article was written by Kate Beioley from The Financial Times and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to firstname.lastname@example.org.
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