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Further interest rate cuts by central banks mean that the rates of return on cash saving accounts are also set to fall, but there are a number of stocks on the UK market that can offer an appealing alternative for investors seeking income.
The Bank of England (BoE) cut interest rates to 5% in August, its first reduction in more than four years. The central bank decided to keep rates on hold in September but BoE governor Andrew Bailey said last week that it could become “more aggressive” in its approach to rates if inflation continues to cool.
However, BoE chief economist Huw Pill appeared to contradict this suggestion in a speech on Friday, in which he said it was “important to guard against the risk of cutting rates either too far or too fast” and emphasised the need for a “gradual withdrawal of monetary policy restriction”.
Inflation came in at 2.2% in August, the same rate as in July, rising slightly from when it dipped to the Bank of England’s 2% target in May and June.
Markets have been betting that the BoE will next cut rates in its November meeting. Other central banks have also been reducing rates, with the US Federal Reserve recently announcing a bigger-than-expected 0.5% cut and the European Central Bank deciding to lower its key deposit rate by 25 basis points for a second time this year.
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What central banks do with their interest rates also influences the rates set by high-street banks and lenders. While this does mean the rate of interest borrowers pay on debt should fall, it also means a lower rate of return from cash savings accounts.
This makes investments that can offer a form of income return on cash more attractive as an alternative, including stocks that have a strong track record of paying dividends.
A dividend is a portion of company earnings that is paid out to some or all investors and is often distributed on a quarterly basis. These payments can act as an indicator of a company’s financial stability.
The FTSE 100 (^FTSE) currently has a dividend yield of 3.59%, according to the London Stock Exchange website.
Data from AJ Bell on Monday showed that analysts expect dividend growth of 1% on the FTSE 100 in 2024 to an aggregate payout figure of £78.6m ($102.85m), which leaves it with a forward yield of 3.7% for the year, based on ordinary dividend payments. Analysts then expected dividends on the blue-chip index to grow 7% in 2025 to aggregate of £83.9bn, leaving a forward yield of 4% next year.
A dividend yield is a percentage that shows the ratio of how much a company pay outs in dividends relative to its share price. While a strong dividend yield is good news for investors, one that is too high may also signal that a company is paying too much of its profits out rather than reinvesting them back into the business, so its important to take that into consideration when looking for the right income stocks.
Finding the right income stocks
Richard Hunter, head of markets at Interactive Investor, said: “There are any number of generous dividend payers in the FTSE 100 index … but of course other factors are at play.”
For example, dividend cover measures a company’s ability to pay out dividends. It does this by working out how many times a company can pay its dividend to shareholders from its net income.
Hunter said: “This gives an indication of whether monies are being distributed from previous profits (a number of less than 1), which is clearly unsustainable.
“By the same token, a number of 1.5 or above is generally accepted to be a comfortable level.”
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In AJ Bell’s dividend dashboard, the platform’s investment director Russ Mould highlighted that forecasts for the aggregate earnings cover ratio for the FTSE 100 are “moving lower as profit forecasts slip and estimates for dividend payments hold firm”.
“Cover in 2024 is expected to come in at 2.07 times according to analysts’ consensus earnings and dividend forecasts,” he said. This figure down from 2.57x in 2022 and would be the lowest since 2020 in the pandemic.
Other factors that investors need to look at when assessing how safe a dividend may be are the balance sheet and cash flow of the business, said Mould.
“They will also need to assess the volatility of profits and, in the case of cyclical stocks whose earnings and cash flow are subject to the vagaries of the economic cycle, look at average earnings over a full cycle to see what degree of cover that provides,” he added.
Income stock picks
Fund manager M&G is currently the highest-yielding stock in the FTSE 100, at 9.5%, according to AJ Bell’s analysis. The stock has a dividend cover of 1.36x and has not cut its dividend in the last decade. The company’s payout ratio of the proportion of its earnings paid out to shareholders as dividends is 74%.
In its half-year results, published last month, the company announced an interim dividend of 6.6p per share, up slightly from 6.5p for the same period last year. M&G reported net client outflows of £1.5bn in the first half, versus £700m inflows last year and said operating profits before tax were down to £375m on the £390m it posted in 2023.
However, M&G CEO Andrea Rossi said the company’s “simplification agenda continues at pace, delivering £121m in cost savings so far”.
Legal & General (LGEN.L)
Insurer Legal & General also has a dividend yield of 9.5% but a cover of 0.87x and a payout ratio of 115%, though the company hasn’t cut its dividend in the last decade.
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Will Howlett, financials analyst at Quilter Cheviot, says that L&G’s “generous” yield is “supplemented by a £200m buyback for FY2024”.
Stock buybacks are when companies repurchase their own shares and can be a way to return cash to investors.
Bank HSBC has among the top 10 highest dividend yields on the FTSE 100, at 7.2%, according to AJ Bell’s data. The stock also has a dividend cover of 2.08x, a payout ratio of 48% and has only cut its dividend in once in the last decade, in 2019.
Howlett said: “Market forecasts suggest an additional 6% yield from buybacks.”
High dividend yields are a “notable feature of many stocks in the financial sector. Major UK banks have committed to returning capital through regular buybacks, in addition to their regular dividends, resulting in total distribution yields exceeding 10%,” he said.
“Although falling interest rates pose a challenge to net interest income, banks have increased hedging to mitigate the impact of rate cuts. Looser monetary policy is expected to boost economic activity, supporting loan demand and fee growth, while keeping loan losses under control.”
British American Tobacco (BATS.L)
British American Tobacco is another high-yielding stock, at 8%, with dividend cover of 1.35x and a payout ratio of 74%, AJ Bell’s analysis showed. The tobacco company last cut its dividend in 2015.
Chris Beckett, head of equity research at Quilter Cheviot, said that while investing in tobacco companies is “frowned upon these days”, for those comfortable investing in this space these stocks offer “deep value and considerable shareholder returns”.
British American Tobacco is one of the best performers in the sector, having “managed to offset the decline in people smoking by raising prices and introducing new generation, less harmful products,” according to Beckett.
In addition, the company is undertaking a £700m share buyback this year and a £900m buyback in 2025, “so the returns to shareholders will continue to be rewarding”, said Beckett.
“The company also expects revenue and profit growth for the full year, and with a valuation at seven times its expected earnings,” he said, adding that it is a “cheap company that provides investors with a defensive option that we expect will continue to do well in the current trading environment.”
Sainsbury’s (SBRY.L)
Interactive Investor’s Hunter highlighted supermarket Sainsbury’s as another option for income-seeking investors.
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The stock has dividend yield of 4.5%, with dividend cover of 1.7x. Market consensus puts a buy rating on the stock, with the share price up 16% on a one-year basis.
Sainsbury’s shares slumped at the beginning of the year but have recovered in recent months, particularly following the release of its first-quarter results in July. The supermarket said sales were up 4.2% year-on-year and reiterated that it expected retail underlying operating profit of between £1.06bn and £1.06bn for the full fiscal year.
Taylor Wimpey (TW.L)
The housebuilder is another stock that Hunter says is worthy of consideration, with a dividend yield of 5.8%.
However, he said the stock is a “marginal inclusion” on his list given its its dividend cover of 1x. That said, consensus is also for a buy rating on Taylor Wimpey, with shares up 40% over one year.
While the housebuilder reported falls in revenue and profits in its first-half results in July, compared with the previous year, Taylor Wimpey CEO Jennie Daly said the company is still expected to deliver group operating profit in line with current market expectations.
Hunter also mentions oil major Shell as another option, which has a dividend yield of 4.1% and cover of 3.2x.
However, he points out the caveat of the influence of recent stock performance, as a “drop in the share price will automatically raise the dividend yield” but still says it is worthy of investor consideration.
Shell warned on Monday that third-quarter refining profit margins were set to be much lower than the previous quarter, in an update note published ahead of results due to be released on 31 October.
Hunter says that there are many other options even within the premier index for income-seeking investors, but adds that these picks also highlight other factors should be “borne in mind to ensure that investors do not look at the dividend yield in isolation”.
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