How safe is the FTSE 100’s 4.2% dividend yield?

The answer depends on whether you believe HSBC Holdings (LSE: HSBA) and Royal Dutch Shell (LSE: RDSB) can maintain their current dividends.

Both stocks offer a yield of almost 8% at today’s prices.

They’re also the two largest companies in the FTSE 100. I’ve calculated that dividends from HSBC and Shell currently account for 22% of all FTSE 100 dividend payments.

If HSBC and Shell cancelled their dividends, the FTSE 100’s yield would fall from 4.2% to 3.3%.

Of course, HSBC and Shell are very unlikely to scrap their dividend, but cuts are a real possibility. In the remainder of this article I’ll explain how this could affect investors in both companies and in FTSE 100 tracker funds.

Why are yields so high?

Ultra-high yields like these are usually seen as a sign that a dividend cut is likely.

Star fund manager Neil Woodford said in a recent interview that he believed both Shell and HSBC were paying unsustainably high dividends.

Shell’s 2016 dividend isn’t expected to be covered by earnings, while the firm’s forecast dividend for 2017 will swallow up 100% of expected earnings. This situation clearly isn’t sustainable in the long run, but it won’t necessarily lead to a cut.

Shell has low debt levels and can borrow money very cheaply. If the group is confident that profits will recover in two-to-three years, then it can probably afford to subsidise its dividend in the meantime.

Over at HSBC, the dividend outlook is slightly stronger. Earnings per share are expected to cover the dividend around 1.4 times in both 2016 and 2017. Mr Woodford’s view may reflect his aversion to the energy and banking sectors. On the other hand, it would be foolish to ignore the views of such a successful investor.

What happens if Shell and HSBC cut?

If Shell and HSBC each cut their dividends by 33%, then each firm’s forecast yield would fall to around 5%. This is in line with the five-year average yield for both stocks. In my view, both companies would still be an attractive buy with a 5% yield.

However, investors who have bought heavily in the hope that the current 7.9% yields will be maintained could see a big shortfall in their expected income. A £25,000 investment in each company would currently produce a dividend income of around £1,975 per year. A 33% dividend cut would reduce this payout to about £1,315 per year.

This highlights the potential risk of having an income portfolio with too few stocks. A big dividend cut can do serious damage to your annual income.

FTSE safety?

The dividend yield from the FTSE 100 is generally seen as being pretty safe, but Shell and HSBC’s outsized yields have created an unusual situation.

If both companies cut their dividends by 33%, as I suggested above, then I estimate that the yield from the FTSE 100 would fall 4.2% to 3.9%.

An investor with a £25,000 holding in a FTSE tracker fund might see their income drop from around £1,050 per year to £975. However, an investor with a £500,000 pension pot invested in a FTSE 100 tracker could see their annual income fall by £1,500 in this scenario.

That’s a potentially serious loss of income.

Indeed, this unusual situation may be one of the reasons why the Motley Fool's investment experts didn't include Shell or HSBC in 5 Shares To Retire On.

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Roland Head owns shares of HSBC Holdings and Royal Dutch Shell B. The Motley Fool UK has recommended HSBC Holdings and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.