Three weeks ago George Osborne delivered his summer Budget which, at the time, received a fairly muted response from markets.
The FTSE 100 index rose 0.22 per cent and sterling fell 0.16 per cent during the hour-long speech. However, upon closer inspection of the details, investors had a little more to think about the next day.
One of the areas touched upon in the Budget was the treatment of dividend income and with this in mind I thought it would be worth looking at dividends a little closer. One of the effects of low interest rates has been the hunt for yield among investors.
Inflows to income funds have understandably been high. The FTSE 100 index currently yields 3.8 per cent compared to one-year deposit rates of 1.09 per cent and the one-year gilt yield of 0.5 per cent.
With 10-year government bonds yielding 2.1 per cent, an investment held to maturity would produce 21 per cent compared to equities producing 38 per cent (assuming no growth in dividends). So the headline case of equities for income looks compelling.
But the headline numbers do not always tell the whole story. Firstly, it is worth noting there is a great deal of concentration in the FTSE 100 index.
In 2004 the top-10 companies by weighting represented 52 per cent of the index and produced 55 per cent of the dividend income. In 2014 the top-10 represented 43 per cent of the index but produced 59 per cent of the dividend income, with the top-five companies responsible for 31 per cent of the total income.
Secondly, the dividend payout ratio is also worth paying attention to. According to Bloomberg, since 2007 UK companies have, on average, paid out 48 per cent of their earnings in dividends.
Before the global financial crisis the payout ratio was around 44 per cent and rose to more than 60 per cent in March 2009, as companies maintained their dividend payments while earnings fell in the downturn; the FTSE 100 index was trading at 3,500 points when the ratio peaked. This is a normal process as companies assume the ratio will fall once earnings recover.
Indeed, by the end of 2011 the ratio returned to the average. But since mid-2012 the index has been rising and so has the payout ratio. At current levels companies are paying out 64 per cent of their earnings in dividends, the highest level since 2007. This increase has occurred without the usual setback in earnings and should prompt questions regarding the sustainability of dividends in the event of a slowdown. To put it another way, the wriggle room that companies have to maintain the dividend in a weaker economic environment has been greatly reduced.
Income is a key component to investment returns and vital to many investors’ financial planning. The reasons for its attractiveness remain clear to see, but as always the devil is in the detail.
Mike Pinggera is senior fund manager on the multi-strategy team at Sanlam FOUR