When we’re investing for passive income, the dividend yield is really important. This tells us what proportion of our investment we can expect to receive in the form of dividend payments throughout the year.
Naturally, if I’m looking for passive income, or use income stocks as part of a compound returns strategy, I’ll want the biggest yields possible. So how can I get them?
Sustainable dividends
First, I need to recognise that big dividend yields can be a warning. They can be just too good to be true. And, of course, no dividend payment is guaranteed — they can be cut or cancelled at any point. So what’s a ‘sustainable’ yield?
I’ll stand a better chance of investing in companies with reliable dividends if I do my research. And the best place to start is by looking at dividend coverage. This indicates how many times a company can pay its stated dividend from earnings. A coverage ratio above two is considered healthy.
But cash flow is another factor. A company that generates a steady income will likely have a more sustainable dividend yield than a firm that generates income intermittently. As such, sometimes I’ll look a stocks with stable cash flow, but lower coverage.
Big dividends now
There’s a handful of stocks on the FTSE 100 that offer big dividend yields. Some of them look dangerously unsustainable like Vodafone, some have yields that are concerning like M&G, and others are just big.
My favourite dividend big hitters include Legal & General (8.3% yield) and Phoenix Group (9.1% yield). Neither have coverage ratios above two but, as insurance companies, cash flow is pretty steady and predictable.
However, neither of these stocks traditionally offer much in the way of share price growth. The majority of their returns come in the form of dividends, and they don’t tend to engage in share buybacks as often as their index counterparts.
I bought both of these stocks in March when the market dipped, thus locking in even bigger dividends. So there could be some upward movement in the share price. But, broadly, these are two stocks I own almost solely for dividends.
Dividends tomorrow
I’m not just investing for the year ahead, I’m investing for the future. And that means I need to be thinking about dividends further down the line.
Most dividend stocks look to increase their annual payments in line with inflation or their performance. Some companies can even increase their dividends quicker than that. But that depends on how affordable the current dividends are.
Two companies I’m buying for the forward dividend — as well as share price growth — are Barclays and Lloyds. They currently offer index-beating yields of 4.6% and 5.4% respectively. And they have impressive dividend coverage, at 4.25 and 3.04 times.
Combine this coverage with continued strong performance in Q1, and there’s cause to assume the dividend will increase at pace. Using analyst forecasts, we can observe a forward yield of 6.4% for Barclays and a 7% yield for Lloyds in 2024.
And these yields would likely still be safe. Going on Barclays’ Q1 performance alone, a 14.6% dividend yield would still keep the coverage ratio above two.
But these are just some of my favourite dividend stocks. There are plenty more top stocks to buy in this beaten-down market.
