Dividend danger zone: An 8% yield too good to be true?

In the 'lower for longer' interest rate environment, the hunt for income has been one of the dominant themes of the investment landscape since the financial crisis.

As we approach the start of 2018, with interest rates remaining stubbornly low at 0.5%, reliable income-paying stocks such as the 'dividend kings' that have grown payouts for 15 years or more will remain in high demand.

But, at this stage in the economic cycle, investors face a predicament: it is becoming harder to source income at a sensible price, evidenced by the fact that companies that were perceived as a safe bet on the income front have been bought en masse and as a consequence are now offering low yields as the price has risen.

For those investors who want to find market-beating yields of 4%-plus, certain compromises need to be made, namely a willingness to accept the greater levels of risk involved.

Various cyclical business, miners and banks for example, are offering yields of more than 4%, but their ability to keep writing dividend cheques is somewhat reliant on the overall health of the economy remaining robust.

Here, as a part of a new occasional series, interactive investor's sister website Money Observer has teamed up with wealth manager Canaccord to highlight dividend shares that may struggle to deliver on the dividend front.

We asked Simon McGarry, a senior equity analyst at Canaccord Genuity Wealth Management, to create the dividend danger zone share screen. McGarry filtered through the 700-odd names in the FTSE All Share index and added the following filters: a market cap of over £200 million, a dividend yield of 4% (higher than the FTSE 100 average) and a dividend cover score of below 1.4 times.

Two other filters were also applied: the first filtered out companies that appear in a financially sound position to pay off their debts, while the second excluded firms where earnings have been upgraded by analysts.

After factoring in all of the above, just six shares remained, highlighted in the table below.

However, McGarry points out that none of these shares should be viewed as 'sell' recommendations. On the contrary, some of the shares that are potentially in dividend danger may actually pique the interest of contrarian investors.

"There are lots of different ways private investors can assess whether a dividend looks vulnerable; the screen I have put together highlights on certain metrics those that are in the danger zone on the basis of certain metrics," he says.

Source: Canaccord Genuity Wealth Management. Date: 4 December 2017

Stock in focus: Inmarsat

Each month, we will look more closely at an individual stock that features in the dividend danger zone. This month we have chosen Inmarsat, a satellite communications business.

It has been a couple of months to forget for Inmarsat after the firm's shares fell heavily into the red in November, dipping to a five-year low after the firm lowered its profit guidance for the year. On a one-year view the share price is down 38%, and as a result its forecast dividend yield has risen, currently offering a 8.4%.

According to McGarry, Inmarsat is not a dividend darling that is loved by income investors; instead the high yield it is offering today is a function of its heavy share price fall in 2017.

He fears there are question marks over the firm's ability to service the dividend for various reasons, but points out first that there are concerns around its pricing power and sustainability of margins across various divisions, but most notably maritime (which accounts for 50% of its revenues).

He adds: "Capex is likely to stay high and reduce Inmarsat's ability to pay a dividend. In addition, net debt/EBITDA for 2017 is expected to be a 10-year high. The dividend won't be covered by earnings in 2017 and 2018. Moreover, a yield of 8% plus seems to suggest the dividend is unsustainable."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.