Beware of dividend yields that look too good to be true

Colin McLean, SVM, comments: Recent activity has brought a welcome bounce in share prices, but it is still too soon to call the end of the bear market. With the immediate prospect of deflation, one worrying pattern seems set to continue; dividend cuts.

Already this year, the biggest dividend payer on the UK market, HSBC, has halved its dividend. This follows cancelled dividends from the banks that sought government help. March saw insurers join the list, with no 2009 dividend from Old Mutual and a halved final dividend at Legal & General. Some consumer businesses have also scrapped pay-outs. It seems that only more defensive sectors like pharmaceuticals, oil majors, tobaccos, utilities and food offer soundly based income.

There is a pattern to the dividend cuts. For companies with high bank debt it makes no sense to add to borrowings by paying out cash. It has taken the reality of recent discussions with bankers to drive this message home. But other types of negotiations could imperil dividends more widely. Even in supposedly defensive areas, some companies will need to address pensions deficits or seek help with contracts. A warning last month from the Pensions Regulator, that pensions must come before dividends, shocked many companies with pension funding deficits.

Utilities and bus & rail operators could also find that discussions on easing the terms of their franchises might involve lower dividends. Very high current dividend yields seem to be pointing to this. Indeed, companies with dividend yields of 6% or more are being given little credit in their share prices for the payout. Low share prices relative to the cash paid out by companies are a stockmarket signal to boards to be more prudent with cash. Institutional investors would rather suffer less immediate income if it saved the penalty of later refinancing in prudent companies with heavily discounted shares. Company boards do not want to end up controlled by banks.

In deflationary times dividend yields were high as investors became more risk averse. In future, investors seeking income may make more use of corporate bonds, rather than relying on shares. However, shares have a role to play in providing income with growth prospects. Where dividends have been re-based to sustainable levels, investors should be encouraged. But the dividend yields that still look too good to be true, may prove to be just that.