Post global financial crisis (GFC) we have, collectively, become accustomed to the extraordinarily low levels of yield available from fixed income securities.
Indeed, the yields available on 10-year US government debt is approximately half of what it was at the end of 2005, while the rate available presently on the German ten-year is a mere 20% of the prevailing rate at the end of 2005. A similar story can be discerned in the credit markets.
Yet equity market dividend yields have not moved in sympathy; for many major markets, the dividend yields available at the end of 2014 were greater than at the end of 2005.
Clearly the levels of prevailing equity market yields in isolation is not a reliable method of assessing market cheapness.
But it is interesting to see that equity investors can now receive a multiple of a region’s 30-year sovereign yield, whereas pre-crisis the dividend income would likely have been a fraction of it.
Historical deviance
At the end of last year, the dividend yield available to US investors was 0.7x the 30-year bond yield, whereas 10 years earlier the income was 0.4x.
Furthermore, UK equity investors received a dividend income 1.3x that of 30-year bond yields at the end of 2014, whereas 10 years previously the ratio had been 0.6x. Germany is perhaps even more notable, with the ratio at 1.9x by the end of 2014, whereas 10 years previously it was 0.5x.
Markets have rallied substantially from their post-GFC lows, and in order to maintain a strong yield their dividends have had to increase by a commensurate amount.
The key question today is whether companies are overstretching to enable them to pay the sorts of yields that are prevailing in the market. Dividend pay-out (DPO) ratios can give us a flavour of this because it considers the amount of earnings paid out to shareholders.
The US, UK and German markets have all seen their DPO ratio rise over the past decade. However, in the US and Germany the rise is modest – 31.5% from 27.4%, and 34.8% from 23.3% respectively – whereas the UK’s pay-out ratio has increased from 37.1% pre-crisis to over 56% at the start of 2015.
This is in part due to the larger weight of the resources and energy sectors in the UK, which have seen substantial reductions in their earnings of late, but it is also likely a symptom of the cult of equity income over here.
Income funds are spectacularly popular at the moment, especially in the UK, but we should always bear in mind that income is only one component of a total return.
In time, we may find that companies that do not chase yield buyers and instead invest in long-term, value accretive projects have returns that outstrip those fixated on providing a honeypot for investors via their dividend policy.
It is reasonable for DPO to increase in the absence of attractive business opportunities, but they should not be increased simply to attract potential investors, and we must tread carefully where firms feel constrained by the need to maintain or grow their dividend in the belief that failure to do so is interpreted as a negative signal in the market.
Total return investors should welcome income, but not for the sake of it.
