One of the great attractions of UK shares versus other markets is the relatively high level of dividend income they pay.
The aggregate dividend yield of the FTSE 100 has spent much of this year above 4%, and was as high as 4.3% last week. That’s a tremendous reassurance if you’re nervous about the direction for markets. If companies pay the dividends in the year ahead that they have paid in the previous 12 months, then you can factor in a 4.3% head-start to your total return.
But there’s that all-important word - if.
Rising dividend yields is not the same as rising cash dividends. It can reflect rising dividends, of course, but also falling share prices and share prices among some of the UK’s biggest dividend payers have fallen this year. It makes their dividend yield looks very attractive, on the face of it at least.
Centrica, for example, now yields around 8.5%. Shell yields more than 5.7%. Such high yields pose a dilemma for investors because they must weigh the attraction of getting that income against the risk that the dividend is cut.
Measures exist that give an indication of how secure a dividend is. ‘Dividend cover’ is one, telling you how many times the dividend is exceeded by a company’s earnings. ‘Pay-out ratio’ is another - the percentage of net income accounted for by the dividend.
Ultimately, however, judging the safety of a dividend is as much art as science. It’s possible, for example, for a company’s management to prioritise the dividend above all else, continuing the payment even during periods when it looks unsustainable. That can’t go on for ever but it may last long enough for the balance sheet to recover.
It can also be the case that a dividend that looks secure can suddenly be at risk if there’s an unexpected deterioration in a company’s financial position, for example if it has debt that gets more expensive to service.
For what it’s worth, the pay-out ratio right now for the FTSE 100 as a whole is 58%. That looks relatively secure when you consider the figure peaked above 68% two years ago, but it is some way above the long-run average for the index of 50%.
Active managers of equity income funds are specialists in assessing the safety of a dividend. They can look at technical measures, listen directly to company management and examine balance sheets to understand the risks of a payment being cut.
Within our Select 50 list of favourite funds, a number are equity income specialists. The Fidelity Enhanced Income Fund builds on the underlying dividend offered by its already high-yielding shares by selling the option to buy some of its shares to other investors. The premium it earns by doing this results in a yield of more than 7.1% currently, although this is not guaranteed.
The JOHCM UK Equity Income Fund. This currently offers a yield of more than 4.7%, although also not guaranteed.
It’s not all about the UK - In overseas markets, the Fidelity Global Dividend Fund has holdings in Asia, Europe and the US with a particular focus on reducing downside price risk.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.