Delivering dividends

For income-starved investors, UK equities have provided much-needed respite in recent years, but the good times may now be coming to an end. While the FTSE 100 Index continues to yield a generous 4% or so, some analysts fear the leading lights of the benchmark will struggle to sustain dividend pay-outs next year.

The broker AJ Bell points out that just 10 companies - Royal Dutch Shell, HSBC, BP, British American Tobacco, GlaxoSmithKline, Rio Tinto, AstraZeneca, Lloyds, BHP Group and Vodafone – account for 54% of all the dividends paid out by FTSE 100 companies. Only five of these have been able to raise dividends over the past 12 months and their dividend cover – the extent to which their earnings are sufficient to pay current dividends – looks sketchy in many cases.

Indeed, only Lloyds Bank offers a dividend cover ratio of more than 2 times’, while seven of the 10 are on ratios below 1.5 times’, the level at which analysts tend to begin worry about the sustainability of pay-outs. The other two, Rio Tinto and British American Tobacco, on 1.66 times’ and 1.54 times’ don’t have much comfort room.

What would it mean for investors if these businesses begin to moderate their pay-out ratios? Well, for those holding affected stocks directly, the impact would be felt immediately. For those investing via funds, meanwhile, the effect might take longer to filter through, but the extent of the damage will also depend on the nature and structure of the funds in question.

In the open-ended fund sector, AJ Bell’s analysis of leading UK Equity Income funds suggests investors and their advisers should be particularly concerned. These funds collectively have more than £7bn invested in low dividend cover shares, the analysis reveals, and their exposure levels are high. Of the 83 funds in the UK Equity Income sector that publish detailed data on holdings, 30 funds hold five or more of the 10 largest blue chips with dividend cover below 1.5 times’ according to AJ Bell. Five funds hold seven or eight of these stocks.

Income-focused investors may want to consider their options during 2020, balancing the need for a decent yield against the risk of nasty surprises. In which case, the investment company sector is well placed to help. While income-oriented investment companies hold many of the same stocks as their open-ended counterparts, they have a trick up their sleeves which can offer invaluable protection against dividend volatility.

Uniquely amongst collective funds, investment companies are allowed to hold back some income earned in good years, set aside in reserve funds, in order to subsidise pay-outs to investors in leaner times. In other words, they can smooth out income volatility, providing investors with crucial reassurance.

The value of this approach is underlined by the annual list of dividend heroes published by the Association of Investment Companies, which charts the growing number of funds that have been able to raise dividends each and every year over extended periods and through different market cycles. More than 20 of these funds have done so every year for 20 years, while a select group of leaders has now gone beyond 50 years.

Investment companies even have the option of paying income from capital, assuming shareholders agree, which means they can offer a resilient flow of dividends even in the most trying circumstances.

From investors’ perspective, the allure is obvious. Very often, what income seekers need more than anything else is a degree of certainty that income will continue to be paid at a certain level. It’s much easier for investment companies to offer this security than for other types of collective fund structure.