The theory is fantastically simple. With bank savings rates at all time lows and bond yields eroding faster than the Sussex coastline, it's time to jump into undervalued – and therefore high yielding – equities to generate returns that can't be found elsewhere.
However, this well-trodden rationale belies the troubles investors face in identifying high yielding shares at a time when the flow of cashflows vital to maintaining dividend payouts can turn to a trickle overnight. Blue chip companies around the world have been slashing payouts. US bellwether GE's decision to cut its dividend last month sent shockwaves around the investment world. And the UK’s banks – once the bedrock of any self-respecting income investor's portfolio accounting for a quarter of FTSE 100 dividends – have conspicuously slashed theirs. 'Will they? won't they' speculation that even trusty payers like BT (currently yielding 20.6 per cent) and Marks & Spencer (8.5 per cent) may rein in their payouts too, continues to bubble and even oil leviathan BP has been forced to publicly state that it would maintain its payout after fears of the first cut since 1992 mounted.
The difference between an 8 per cent dividend yield and a 3 per cent rate on a cash ISA doesn't look that attractive when the risks of owning equities are taken into account. Equity dividend hunters face a very real possibility of significant capital erosion in addition to the threat of dividend cutbacks. An 8 per cent annual yield is no comfort if your initial capital happens to be worth 8 per cent less at the end of the year.
Worst not necessarily over
There are many seasoned observers who believe that the worst days of the FTSE are not yet behind us and that we could realistically see the FTSE drop by as much as a quarter from today's 4000 level. An 8 per cent annual yield in the context of a 25 per cent drop in the value of the underlying capital is a frightening prospect. So, while the temptation may be to lock in those high yields before they evaporate, this actually raises the risk of capital depreciation.
The trick, then, is not just to identify companies whose dividend payments look safe, but whose underlying value looks safe, too.
An unusually high dividend yield is a near sure sign that the dividend is likely to end up on the chopping block. There are currently 21 companies historically yielding over 10 per cent, but it would be almost Panglossian optimism to expect a payout at this level from any of them.
But within this select group are four Reits; Segro (56.6 per cent), Land Securities (15 per cent), British Land (12.1 per cent) and Hammerson (10.7 per cent). Reits remain an interesting prospect, as they are forced to pay out a proportion of rental income as dividends. Broker KBC Peel Hunt recently upgraded Segro to a buy on the basis that it would be yielding 9.3 per cent after its rights issue and also noted that Hammerson, British Land and Land Securities would all yield over 6 per cent ex-rights. Shares in these recently recapitalised companies have fallen an average of 65 per cent over the last 12 months, so the prospect of a long-term equity recovery is also tempting.
If the market is facing further turbulence, then the much repeated advice to target defensive sectors like tobacco, utilities and pharmaceuticals that offer a 'safe' yield still makes sense, even though non-cyclicals have come under recent pressure. Shares in defensives held up well during the 2008 bear market, so should do the same in 2009 if markets continue to slide. Among the defensives, companies like AstraZeneca (5.8 per cent), Glaxosmithkline (5.5 per cent), BP (6.4 per cent), Royal Dutch Shell (6.4 per cent and borrowing to increase the payout) all held their value well in 2008, as well as more than holding their dividends.
