This global fund manager is questioning the sustainability of dividends in Australian stocks

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The Australian stock market has one of highest yields in the world, with investors enjoying a 2% yield margin pick up over the MSCI world index, according to State Street Global advisors.

Throw in imputation credits for Australian resident investors and there is an additional “1.5% to this already healthy margin” says Olivia Engel, State Street’s head of active quantitative equities for AsiaPac and senior portfolio manager Toby Warburton in their latest newsletter.

But investors need to be careful not to get lulled into a false sense of security, the pair said:

The perceived reliability of Australian dividend income could lead some investors to think of the market as being almost “bond-like”. This is a potentially dangerous misunderstanding. The capital value of an equity security is far more at risk than a bond. Furthermore, unlike bond coupon payments, dividend payments are not fixed. A company can change its dividend at any time.

They highlight that over “last five years, payout ratios have climbed to very high levels in aggregate (from 55% to 85%), while dividend yields have remained around the same levels (4.5%-5%)”.

That’s been possible, Engel and Warburton say, because resource companies and banks, to a lesser extent, have held their dividends steady “while experiencing a fall in earnings”.

But the risk is skewed toward lower dividends in the future.

“Earnings need to improve to sustain dividends in the Australian market from here, as payout ratios cannot increase much further, and probably need to come down. The Australian market is not immune from having payout ratios or dividends cut substantially, as was seen after the Global Financial Crisis in 2009,” the pair said.

They argue that while investing for the income dividends deliver may seem like a sensible long-term strategy, there are risks for investors.

Given their worry about the sustainability of dividend payments Engel and Warburton warn “there is no guarantee that last year’s dividend payment will be repeated this year or even that forecast dividends from sell-side analysts will be paid this year”.

That means that a “strategy of blindly buying companies with the highest reported dividend yield could expose investors to some high-risk securities”.

They believe that while a strategy that includes the long term purchase and hold of securities for the dividend payment flow may have merit, investors need to be able to ride out the swings in the value of the shares.

Australian Major Banks daily over the past year (Reuters Eikon)

“Income investing has a long and proud tradition; however, for investors who prize short-term capital stability and want a smooth trajectory of total returns, a more nuanced approach is needed” they said.

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