Equity income

  • Written by 
  • 16/09/2013
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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Shares that pay high dividends have always been attractive to investors looking for income for one very good reason: unlike coupons (the interest rates that bonds guarantee to pay until maturity), dividends have the potential to increase over time. This allows you to share in the success of a company and may provide some protection against inflation in the long term.

However, it is important to be aware that shareholders rank lower than bondholders when it comes to rights over a company’s cash and assets, so shares carry higher risks than bonds in the same company. It is no good focusing simply on how high a share’s dividend yield is; equally important is how sustainable that dividend yield will be.

A very high yield is usually a sign that investors do not think a company can continue to pay such a large dividend, and that a cut may be imminent. So before you invest in any high-dividend stock, it is important to consider the issuing company’s profitability, the strength of its balance sheet and the long-term outlook for its business.

Before you invest in any high-dividend stock, consider the issuing company’s profitability, balance sheet and long-term outlook.

One metric you should check is “dividend cover” – the ratio of the company’s net profits to its dividend payments. A common rule of thumb is that in order for a dividend to be affordable, net profits should be at least 1.5 times higher (although some industries with very stable earnings, such as utilities, can sometimes afford to have lower dividend cover).

Compared with other types of income investment, high-dividend shares have not seen their yields fall as sharply in recent years. Indeed, the Société Générale Global Quality Income Index – an index that aims to include good-quality companies with strong, sustainable dividends from around the world – has an average yield of about five per cent at present, in line with its theoretical level since 1990 (theoretical because this is a fairly new index and historical data comes from back-testing).

So, for investors who are able to accept the greater risks and volatility that come with investing in shares rather than bonds, high-dividend shares may represent today’s most attractive income option. It is not just the risk of a fall in dividend or no dividend at all but the risk of loss of some, or all of the capital invested that must be acceptable.

Investing ideas

The Edinburgh Investment Trust and Invesco Perpetual High Income Fund are two of the UK’s most popular equity income investments. Both are run by Neil Woodford: perhaps the country’s best-known investment manager. However, the former trades at a persistent premium to the value of its assets, while the latter now manages more than £12 billion, which could limit its flexibility.

If you are looking for a much smaller fund, one possibility would be the Aberdeen UK Equity Income Fund, which has a four-crown rating from Financial Express. If you are interested in dividend-paying shares from elsewhere in the world, the Newton Global Higher Income Fund is a popular choice.