Sky-high interest rates and unruly inflation make the future direction of the economy more uncertain than usual. It is certainly no time to be complacent.

Against such a tough backdrop now is a good time for investors to take stock and consider if the income they expect from dividends in their portfolios are safe.

Investors are often attracted to the highest yields, but this can indicate markets do not believe the dividend will be paid in full.

This article looks at some of the highest dividend yields available in the UK market and identifies which look safe and which may be at risk.

To the casual observer things don’t look too bad for the UK income investor. The latest dividend dashboard from AJ Bell (4 September) shows the FTSE 100 is expected to pay total dividends of £78.7 billion in 2023.

Adding £46.6 billion in share buybacks already announced to the tally would make 2023 the second best-ever year for FTSE 100 dividends and buybacks since 2018.

However, before cracking open the bubbly, it is worth noting the deteriorating trends in forecasts. For example, in the last three months analysts’ forecasts for pre-tax profit growth have dropped from 19% to just 10%.

Meanwhile, at the end of the second quarter dividends from the FTSE 100 were expected to total £83.8 billion which means analysts have trimmed their forecasts by around 6%.

It is important to emphasise, dividends are discretionary payments and cannot not be considered set in stone by investors.

DIVIDENDS ARE NOT ALWAYS AS SAFE AS THEY LOOK

Dividend cuts and suspensions can appear form seemingly nowhere. Take manufacturer and supplier of critical power components XP Power (XPP) which surprisingly scrapped its second half dividend (2 October) amid a collapse in demand.

Running close to covenant limits the company is now in cash conservation mode. ‘We are taking appropriate mitigating actions to reduce costs and conserve cash’, the company said.

Dividends have been a key part of the investment case for XP Power and excluding the pandemic period the company has never skipped a dividend since floating on the stock market 23 years ago.

With the cost of debt increasing and the economy deteriorating, it is a time to be extra vigilant.

DEFINING THE UNIVERSE

Using Sharepad software we screened for companies with a dividend yield of more than 6% and added a filter requiring a dividend cover of at least 1.5 times, the results can be seen overleaf.

Unfortunately, there isn’t a magic formula for spotting safe or risky dividends. As mentioned, a very high yield is usually a red flag. In other words, if it looks too good to be true, it probably is. Dividend cover, i.e. how many times the dividend is covered by earnings, is also a useful if imperfect metric.

High dividend cover isn’t a guarantee of safety as XP Power demonstrates, which had a forecast yield of 8.3% and a cover of just under two times before it suspended its payout. Other factors to consider include the cyclicality of the business, recent trading and balance sheet strength.

Resources companies occupy the top end of the table, offering some chunky yields, but it should be remembered they are very cyclical, and some operate in parts of the world which are politically unstable.

Banks also feature with yields of around 8% for NatWest (NWG) and HSBC (HSBA). Their dividends are covered by around two times by earnings which suggests they could be safe.

Banks are benefiting from higher interest rates which increase their net interest margins, but it is also worth noting that the cost of funding (interest on customer deposits) has also increased.

The investment narrative could change quickly if the UK economy slows further or enters recession. Investors will then likely be more concerned about rising bad debts and general credit deterioration.

HSBC may be more insulated from UK specific worries given the UK represents a small part of its overall business.

Read on to discover five big dividend yields we think you can trust and three which are too good to be true. We have gone outside of our screening exercise for some of the selections, trusting to our knowledge and experience.

FIVE BIG YIELDS YOU CAN TRUST

Aviva (AV.) 421.6p

Forecast dividend yield: 8.6%

The UK’s largest general and life insurer Aviva (AV.) has been through a major transformation since chief executive officer Amanda Blanc took over in 2020, effectively exiting France, Hong Kong, Indonesia, Italy, Poland, Singapore, Turkey and Vietnam, raising billions of pounds and buying back millions of shares with the proceeds.

Meanwhile, the core UK and Irish businesses continue to go from strength to strength, as demonstrated by the group’s first-half results with general insurance premiums up 13%, Workplace wealth net flows up 25% and private health insurance sales up 58%, and its Canadian business grew first-half sales by 12%.

Analysts at Jefferies believe Aviva has the strongest free cash flow in the sector and see a shift towards more capital-light activities leading to a premium valuation for the shares.

The 2023 and 2024 dividends are seen covered between 1.2 times and 1.3 times by earnings, lower than you would like for some sectors but not unusual in the insurance space, we believe investors should lock in a yield north of 8%. Takeover chatter has recently lit a fire under the share price with a several overseas parties reportedly mulling a 600p per share offer. [IC]

British American Tobacco (BATS) £24.75

Forecast dividend yield: 9.6%

For income investors prepared to set aside any ethical objections, British American Tobacco (BATS) looks an interesting option with a yield approaching double digits.

The tobacco firm faces regulatory headwinds – notably the UK announcing plans for legislation which would mean today’s 14-year-olds will never be able to buy a cigarette in their lifetime in this country – but this is nothing new for an industry which has faced such pressures for decades.

Fundsmith Equity (B41YBW7) fund manager Terry Smith argues these businesses benefit from regulation in the sense there are unlikely to be new entrants to the market and, because there are restrictions on their ability to invest in marketing, this means there is more cash left over for shareholders.

British American generates lots of cash – projected to be approximately £40 billion over the next five years – which provides a measure of confidence in its policy of paying out 65% of its earnings in dividends. The recently agreed sale of its Russian business will mean a modest hit to revenue and profit but removes a key headache for management and the company continues to invest in a pivot towards next generation products including vaping. [TS]

Serica Energy (SQZ:AIM) 222.6p

Forecast dividend yield: 8.2%

North Sea oil and gas firm Serica Energy (SQZ:AIM) offers a generous yield despite a strong balance sheet and robust energy prices – this presents an opportunity for investors.

Having previously been almost exclusively focused on producing natural gas, the company added oil to the mix through the £367 million acquisition of Tailwind Energy which completed in March 2023. Its output is now 55% gas and 45% oil and the transaction also made Serica one of the top 10 North Sea producers by volume.

Despite taking on debt as part of the deal, first-half results published on 18 September revealed the company was still sitting on net cash of £234 million as of 30 June 2023, having generated cash flow from its operations of £266 million through the period.

One risk to the dividend is M&A which remains a key part of the company’s strategy. However, the 12.5% increase in the first-half dividend is a marker of the company’s commitment to continue rewarding shareholders in this way.

Serica’s enviable financial position should allow it to invest to help sustain and build its production, both organically and through acquisitions, providing the cash flow necessary to fund dividends. [TS]

Smiths News (SNWS) 41.5p

Forecast dividend yield: 9.7%

Newspaper and magazine wholesaler Smiths News (SNWS) offers a 9.7% prospective yield with the anticipated 4.1p dividend covered 2.6 times by expected earnings. The shares trade on a bargain basement rating of four times forecast earnings for the year to August 2024. So, what’s the catch?

The market seems to be pricing Smiths News as a company in terminal decline. Admittedly, there are question marks about the long-term future of supplying print-based publications given so much media is now consumed online. Yet it could be a slow descent, not the market disappearing overnight.

Smiths News has delivered a generous stream of income to shareholders as compensation for the risks associated with investing in the business. That is likely to form the bulk of your returns. Any capital gains will be a bonus – although there is also the potential for capital losses.

The share price over the past five years has followed a repeated pattern. It goes nowhere for a while, it then falls before bouncing back, and then does the same thing again.

The latest trading update (4 October) was robust and half-year results in May talked about major contract renewals, a sharp decline in average net debt and ambitions to find new profits streams beyond magazines and newspapers. This business could be around for longer than the market thinks. [DC]

Telecom Plus (TEP) £15

Forecast dividend yield: 5.7%

With winter looming for Brits, household energy bills will quickly become a big talking point, and with more stable wholesale pricing compared to a year ago, expect a lot of account switching, usually good news for Telecom Plus (TEP).

As a multi-service provider, the company – trading as the Utility Warehouse – has the scope to pivot its sales drive to match consumers biggest concerns at any time, a great lever to keep new subscriber numbers bubbling higher and cash flows stable, vital for sustainably growing shareholder dividends.

Telecom Plus excels at steadily upping income for shareholders, even managing to hold the payout during the worst of the Covid pandemic, and not many companies can say that. This speaks volumes for the financial management of the business, as does the fact that in fiscal 2023 (to 31 March) it increased the per share payout from 57p to 80p (up 40%) despite overall dividend cash costs increasing only 13%.

Consensus points to per share dividends rising to 85.2p and 89.4p this year and next, implying am income yield of 5.7% and 6%, and prevailing management optimism at May’s fiscal 2023 results in May will see them mull share buybacks as a way of underpinning shareholder returns. [SF]

THREE HIGH YIELDERS TO AVOID

BT (BT.A) 115.2p

Forecast dividend yield: 6.6%

Vodafone (VOD) 76.4p

Forecast dividend yield: 10.2%

New broom CEOs are sweeping into BT (BT.A) and Vodafone (VOD) in a desperate roll of the dice to get growth going again. BT revenue have increased just 13% in a decade, Vodafone sales are virtually flat.

Given shareholder returns have been dismal for years, something’s got to give – it’s not rocket science, and dividend payouts are bang in the frame. Forecast yields are 6.6% and 10.2% respectively and consensus expects zero growth anytime soon. Worse, Shares believes there is enormous rebase risk for future dividends given this is a common move for incoming CEOs something analysts seem to be slow to admit.

It’s only the promise of bumper income yields that have stopped more shareholders dumping these two stocks, yet with BT’s cash flows largely tied up with fibre network rollout, and Vodafone attempting to tie the knot with mobile rival Three in the UK, investors can expect even more pressure to build on balance sheets already piled high with debt (approximately £20 billion and €47.7 billion net debt),

That their share prices are down 66% or so each over the past decade yet annualised total returns are only mildly negative (-4.65% for BT, -1.2% for VOD) tells you how important dividends have been for both investment cases. [SF]

Taylor Wimpey (TW.) 112.5p

Forecast dividend yield: 8.2%

UK housebuilder Taylor Wimpey (TW.) offers an enticing dividend yield of 8.2% based on consensus analyst forecasts, but Shares believes there are risks to the dividend over coming months.

Chief among them is that the Bank of England holds interest rates higher for longer which will squeeze consumers and potentially lead to bigger than expected fall in house prices.

Although Taylor Wimpey has a strong balance sheet with net cash of £655 million, analysts are forecasting EPS (earnings per share) will more than halve over the next two years.

If this were to happen it means earnings would no longer cover the anticipated dividends and the company would have to dip into its cash reserves.

This may test the resolve of management who have committed to paying 7.5% of net tangible assets per share in dividends. [MG]

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