Dividend outlook – 2021 to bring back yields?

Lots of us want our investments to make us an income. Whether that’s to store away for future investments, or for day-to-day spending.

Unfortunately, UK dividends fell over 49% in the third quarter of 2020, the lowest third quarter fall since 2010. However, the outlook for 2021 is a bit brighter.

This article isn’t personal advice. If you’re not sure if an investment is right for you please seek advice. All investments can go up and down in value, so you could get back less than you put in.

The dividend dilemma

As lots of investors will know all too well, not all dividends are created equal. A high dividend yield might sound enticing, but it can be a warning sign too. As with everything in life, if it sounds too good to be true, it probably is. You need to ask yourself if the dividend is sustainable.

Companies make dividend payments using the cash they have left after covering their necessary expenses – things like payroll and rent. Management will decide whether to reinvest that money into the business or return it to shareholders. Rising costs, declining revenue, or some combination of the two could make it impossible for a company to keep up its dividend obligations.

A good way to evaluate whether a dividend is sustainable is looking at the company’s coverage ratio. A dividend cover ratio compares underlying income to dividends paid. It lets you know how many times a company could cover dividend payments with existing income.

Dividend cover ratio = Profits After Tax/ Gross Dividends Paid

Generally speaking, a coverage ratio below 1.5 is worth keeping an eye on. It means the company is making only slightly more than it’s paying in dividends. Anything approaching 1 should raise serious questions about whether the dividend is sustainable, since the company is paying out almost all its profits as dividends.

However, what’s normal in one sector could be outrageous in another. It’s important to compare ratios between industry peers.

Investing in an individual company is higher-risk and isn’t right for everyone. Your investment is dependent on the fate of that company. If it fails, you risk losing your whole investment. Investors should only buy and hold individual shares as part of a well-balanced, diversified portfolio.

Remember no dividend is ever guaranteed, and yields aren’t a reliable indicator of what you’ll get in the future. Past performance isn’t a guide to the future.

Dividend pay-outs – winners and losers

The flurry of dividend cuts was to be expected last year considering the pandemic’s impact on the global economy. But as vaccine hopes take centre-stage what’s the outlook for 2021?

Oil and gas dividends come down to earth

Dividend yields in the oil and gas sector have long been rather chunky. But the combination of a global supply glut and coronavirus driven collapse in demand pushed oil prices to historic lows in 2020. Dividend payments were rapidly reduced.

12 Month Forward Dividend Yield (%)

Past performance is not a guide to the future. Source: Refinitiv Datastream 31/12/2020.

The sector’s still home to some very respectable yields. That’s thanks to large falls in share prices, which have pushed yields higher despite dividend cuts.

Take BP, whose 12 month forward dividend yield was 6.0% as of December 31, 2020, compared to 6.9% in mid-2019. BP’s declining share price, not increased dividend payments, are the reason for the bump. BP actually cut its dividend nearly in half in both the second and third quarters this year – a move that appears to be permanent.

BP share price, charts and research

Pandemic or not, the future of the energy sector is in question and major players are increasing their focus on cleaner energy. While that could offer long-term stability, it’s going to take a lot of investment and means they’ll have less cash to pay out in dividends. Others are all-in on traditional oil, which could be cheaper in the near-term, but could be a poor long-term choice.

In either case, we think dividends in the oil and gas sector are unlikely to return to their former highs any time soon. For now, most of the majors have coverage ratios above 1, meaning they can cover their dividends at current levels, but not comfortably.

Royal Dutch Shell share price, charts and research

Regulators let banks off the leash

Much like the oil and gas sector, bank stocks also saw their yields fall this year. This was due to regulatory changes that pushed financial institutions to stop paying dividends in order to protect their balance sheets.

12 Month Forward Dividend Yield (%)

Past performance is not a guide to the future. Source: Refinitiv Datastream 31/12/2020.

As with oil stocks above, bank stocks have dropped substantially in 2020.

However, we think the sharp drop-off in bank stock dividends is likely to be short-lived. Regulations preventing financial institutions from paying dividends have been relaxed, paving the way for banks to resume pay-outs at least in-part.

The Bank of England has capped dividend payments at 25% of profits, or 0.2 percent of risk-weighted assets, which will keep lots of banks from paying out as much as they were pre-pandemic. Still, that restriction is unlikely to last forever and will probably be removed once pandemic woes subside. With that in mind, bank dividends are expected to creep back up to previous levels over the next two years although there are no guarantees.

Lloyds Banking Group share price, charts and research

HSBC share price, charts and research

Barclays share price, charts and research

Natwest share price, charts and research

Building wealth with housebuilders

The FTSE 350’s housebuilders have offered respectable yields over the past 5 years. Like the rest of the market, the sector saw a slump in yields due to the pandemic, but that decline’s likely to be short-lived as the housing market has so-far escaped the crisis relatively unscathed.

12 Month Forward Dividend Yield (%)

Past performance is not a guide to the future. Source: Refinitiv Datastream 31/12/2020.

Housebuilders could still suffer, since an economic slump would hurt demand moving forward. It’s also unclear whether lockdowns coupled with the stamp duty waiver pulled 2021 demand forward as people rushed to move out of major cities and take advantage of the perceived savings.

Before coronavirus hit, housebuilders’ dividends were looking increasingly attractive with yields over 4%. As long as the housing market holds up we could see housebuilders revive their dividend payments, potentially climbing back to 2019 levels.

Barratt Developments share price, charts and research

Vistry Group share price, charts and research

Taylor Wimpey share price, charts and research

Persimmon share price, charts and research

Boring is sometimes best for dividend security

Utilities tend to get a lot of attention in times of economic uncertainty because of their predictable, potentially secure, revenue streams. Their above-average dividend yields also make them attractive.

12 Month Forward Dividend Yield (%)

Past performance is not a guide to the future. Source: Refinitiv Datastream 31/12/2020.

While investing in utilities isn’t nearly as exciting as buying a high-growth tech stock, sometimes boring can be best. Utilities provide necessary services like water, electricity and waste collection. Even if the pandemic continues to worsen, demand for utilities is probably here to stay.

Heavily regulated profits mean growth is hard to come by but can translate into predictable revenues.

Valuations in the utility sector have risen as more investors look for recession-resistant stocks, and that’s dented yields slightly. Still, we think utilities could remain a key area of focus for seeking income.

National Grid share price, charts and research

Severn Trent share price, charts and research

United Utilities share price, charts and research

SSE plc share price, charts and research

A final word on dividend stocks

As the pandemic proved to us in 2020, there’s no such thing as an iron-clad dividend. Still, it makes sense to find sustainable yields in sectors that are likely to see growth in the years ahead. Diversity is key though, and pigeon-holing your investments in one sector carries its own risks.

The author holds shares in Lloyds Banking Group.

This article is not personal advice or a recommendation to buy, sell or hold any investment. If investors are not sure of the suitability of an investment for their circumstances, they should seek advice. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv.

These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future and investments rise and fall in value so investors could make a loss.

This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing.

Please see our full non-independent research disclosure for more information.

Share insight: our weekly email

Sign up to receive weekly shares content from HL