Investors tempted by high yields could be at risk of being caught in a potential ‘dividend trap’ as research found that half of the world’s highest-yielding non-financial companies do not have sustainable payouts.
While global profits have continued to grow strongly in 2019 and are expected to hit £2.4trn by the end of the year, dividend cover – a key measure of dividend sustainability – has fallen for several reasons.
Research by the Henderson International Income trust found that 81 of 163 of the highest yielding non-financial companies in the Janus Henderson Global Dividend index are potential traps.
Dividend cover is expected to fall to 2.2x – the lowest level since the 2008 global financial crisis when cover was just 1.4x – despite record forecast payouts of £1.1trn for 2019, an increase on last year’s £1trn.
Source: Henderson International Income trust
Cover has fallen due to a combination of a maturing economic cycle, industry-specific developments and cultural changes in Japan and the Asia-Pacific region.
Ben Lofthouse, manager of Henderson International Income Trust, said companies featured in the Janus Henderson Global Dividend index responsible for one-fifth of global payouts (worth £230bn) could be considered dividend traps and were “potentially unsustainable, especially if the global economy weakens”.
“Typically, dividend cover rises quickly as an economy turns upwards,” said Lofthouse (pictured). “A long economic expansion is then associated with a steady decline in cover ratios as companies loosen the purse strings.
“And finally, an economic contraction causes sudden drops in dividend cover before the process begins again.”
According to Henderson International Income Trust, 70 per cent of companies have seen dividend cover fall in the past five years.
He added: “We are not concerned about falling dividend cover because it was unnecessarily high in the past in some sectors and some parts of the world.
“By taking an international approach to investing, income is better covered by profits and better diversified across different industrial sectors and between economies at different stages in the economic cycle and in their development.”
Nevertheless, Lofthouse said some sectors and countries were healthier than others.
On a geographical level, dividend cover reflects the local dividend culture and the mix of sectors.
Australia consistently has the lowest level of cover standing at 1.4x in 2018, according to Lofthouse. This is due to a large share of companies’ profits paid out as dividends due to favourable tax treatment and a stock market dominated by large mature banks with limited growth opportunities.
The UK has the third-lowest dividend cover figure of 1.6x, due to the composition of the market; it is dominated by large oil & gas names, pharmaceutical manufacturers, global banks and utilities companies.
Source: Henderson International Income trust
Michael Kempe, chief operating officer of Link Market Services, said that dividend growth in the UK “is slow and relies on a handful of companies in a few sectors”.
“This doesn’t mean UK companies are not a great source of income for investors – in fact yields on UK stocks are very attractive at present, and the mix of companies is skewed towards mature high yielders – but it means that investors must be sure to diversify,” said Kempe.
However, Kempe noted that UK yields remain attractive and that dividends would have to fall more than during a severe recession to bring the yield back in line with historic averages, adding: “A decline of that size is extremely unlikely.”
So where do investors have a good chance of avoiding ‘dividend traps’?
The country with the highest dividend cover is South Korea at 4x in 2018, almost double the global median figure. This reflects strong growth in profits seen in the South Korean market.
In the US dividend cover is higher due to the propensity of companies to favour buybacks as a means of returning cash to shareholders.
On a sectoral level, companies with steady, stable earnings can sustain dividends at much lower cover levels than those which are more sensitive to the economic cycle.
For example, tobacco and utilities maintain low dividend cover while oil & gas companies cover can rise and fall dependent on commodity price fluctuations.
Source: Henderson International Income trust
“Each sector has its own dynamic across the economic cycle, is at a different level of maturity or is encountering disruptive forces,” noted Lofthouse. “Dividend cover varies accordingly.”
Profit performance is likely to become patchier for different sectors and countries depending on where the impact of a global slowdown is greatest, said the Henderson International Income trust manager, and some companies could allow their dividends to drop.
However, some companies may decide to hold their payouts steady for a time and for the time being remains relatively comfortable at a global and sectoral level.
UK investors may want to consider greater income diversification, particularly given the uncertain market environment caused by Brexit.
“It would be rash to abandon the UK at the moment as for income it looks exceptional value,” added Adrian Lowcock, head of personal investing at Willis Owen.
“However, if you are in need of income then the most important thing is to diversify your income streams to reduce volatility and dividend risks.
“Looking ahead, 2020 is very unclear. Whilst we think a global recession will be avoided the lack of clarity around Brexit makes it very hard to forecast any further ahead for the UK.”