If we’re investing for passive income or use a compound returns strategy for growth, we’re going to be paying a lot of attention to dividend yields.
Naturally, the higher the yield — assuming the yield is sustainable — the better. And in the current market, there’s no shortage of high-yielding dividend stocks.
So, why now? And what stocks should I pick?
Why now?
As we know, share prices and dividend yields are inversely correlated. When share prices go up, dividend yields fall and vice-versa.
And currently, the market isn’t surging. In fact, the FTSE 100 is down 1% over five years, and the FTSE 250 is down 9% over the same period. This is indicative of the dip we’re in.
Naturally, some sectors are performing worse than others. UK-focused stocks tend to be performing worse than their multinational counterparts — this, to some extent, will reflect ongoing uncertainty around Brexit, and the UK’s economic underperformance.
However, I don’t expect this dip to last forever. For one, earnings have largely held up despite this latest challenging period, which means current valuations are looking very tempting.
So, with UK stocks at a low ebb, it’s time to lock in the resulting high dividend yields. That’s certainly what I’ve been doing.
Sustainable yields
Unfortunately, sometimes, a big dividend yield is just too good to be true. Of course, we know that dividends aren’t guaranteed and they can be cut at any point. But, if we do our research, we can certainly increase our chances of investing in stocks with sustainable yields.
The first place to start is the dividend coverage ratio (DCR). This is a financial metric that indicates the number of times a company can pay dividends to its shareholders from its earnings. Normally, a DCR above two is considered healthy.
Personally, I consider some companies with DCRs below two as well. That’s because cash flow is also important here. Some companies have more regular cash flow than others. For example, pharma stocks may generate very little for some years, but then have windfall when a treatment gets the green light. Meanwhile, insurance companies, for example, tend to have more reliable revenues.
The stocks!
So, we’re looking for high-yielding dividend stocks with strong coverage. I’m starting with two fairly boring ones — Lloyds, which currently has a 5.3% dividend yield, and Barclays, which has a 4.6% dividend yield.
These are by no means the biggest yields out there. However, coverage is very strong, at 3.04 and 4.25 times. This gives these banks room to grow the dividend in the coming years. Analysts forecasts suggest both these firms will have forward yields around 6.5% in 2024.
But looking at higher yields, I also like insurers Legal & General and Phoenix Group, which offer 8.2% and 9% yields. Both stocks have coverage ratios below two, so there’s more risk that the dividend will be cut. However, I bought these stocks because they’re strong cash generators.
These are just a handful of my favourite dividend stocks right now, but there’s plenty more to choose from.
