Disappearing dividends

By ADRIAN LOWCOCK 19/05/2009

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As was widely expected, Marks and Spencer cut their dividend today and they are unlikely to be the last company to do so this year. Indeed, as the recession bites into the main economy, dividends during 2009 will fall.

There are some sectors which are defensive in nature and should provide some security to investors, protecting them from the bulk of the falls. These include utilities, pharmaceuticals, oil and tobacco. However, during the last recession in the 1990s, it was only pharmaceuticals that didn’t cut their dividends. This time around the recession is expected to be much deeper and last for longer so it would be prudent to expect a similar situation.

Company dividend yields are based on historic figures and not current earnings. It is therefore difficult to identify which companies are going to continue paying their dividend.

What action can you take?

To protect against individual companies cutting their dividends investors can look to spread their risk by investing in funds. Furthermore investors should look to obtain income from a variety of sources to provide additional protection and security.

Equity income funds

If you invest in a managed fund with an income objective, unlike a single company’s shares, you are investing in the managers’ skills and research capabilities to identify and buy those companies who are least likely to cut their dividend. Managed funds can also invest in companies that the manager feels are undervalued and offer exceptional income opportunities at current market prices.

Bestinvest recommendations

Corporate bonds

For income seekers, equities and the dividends that they pay might be too volatile. Corporate bonds are a traditionally less volatile asset class, which basically locks into a yield at the point of investment - corporate bond funds invest in company debt. With these funds, the yield can change as the manager moves from one bond to another. However, the market is very efficient and less erratic than equities, providing greater certainty and stability at the expense of long term growth.

Bestinvest recommendations

Enhanced income funds

With cash deposit rates falling to zero and even some high income accounts offering a disappointing 0.1%, fund managers have recently been launching enhanced income funds. These take advantage of the UCITS III Directive allowing managers to use some derivative tools to enhance returns. Some managers use this to write options and sell them for a premium, using the income generated to boost the yield of the fund. The increase in risk (of the option being called) is minimised by the fund already owning the shares the options are written against. This also impacts upon the growth potential of the fund. Investors sacrifice growth for income.

Bestinvest recommendation

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Source: Financial Express