Legal & General (LSE: LGEN) shares have taken a bit of a tumble in recent weeks, falling from 266p to 243p. As a result, they’re now sporting a dividend yield of around 9% again.
Are they worth considering for this enormous yield? Let’s discuss.
A massive yield
A 9% dividend yield is no doubt attractive. But in the investment world, there’s no such thing as a free lunch.
So, we need to look at the investment risks here. Why are the shares sporting a massive yield (more than twice the average FTSE 100 yield) and what’s the catch?
What are the risks?
Looking at the company and the stock today, I see a few issues that investors need to be aware of.
First, dividend coverage (the ratio of earnings per share to dividends per share) is very low. This year, it’s forecast to be under one.
A ratio under one is generally a red flag as it signals that earnings won’t cover dividends. In other words, the payout may not be sustainable.
It’s worth noting here that a dividend cut can lead to disappointing returns. Often, investors are faced with both lower-than-anticipated income and share price losses.
Gilt uncertainty
Second, looking at the recent share price action, it’s pretty obvious that big institutional investors are concerned about UK fixed income holdings (gilts) on the insurer’s books.
You see, last week, gilts made headlines after long-term UK borrowing costs hit their highest levels since 1998 on the back of concerns over Britain’s economic outlook. And this is exactly when the Legal & General share price started to tank.
The issue here is that Legal & General is a major player in the liability driven investment (LDI) space. This area of investing involves projecting liabilities (say, of a pension scheme) into the future and then generating returns from available assets (equities, bonds, gilts, gilt derivatives, etc) to meet the liabilities.
Now, when volatility spikes in the gilt market, it can create serious challenges for LDI investors that own gilt derivatives. In this scenario, firms can face margin calls on their gilt derivative positions, leading to problems with liquidity, balance sheets, and dividend payments (and most likely share price losses).
So, there’s definitely some uncertainty here.
Worth the risk?
Despite all these risks, the insurance stock could still be worth considering today. Because in the long run, this company does have a number of growth drivers.
These include rising equity markets (which should benefit its investment management division), growth of the pension risk transfer (PRT) industry, and growth of the alternative investment markets (an area the company has been moving into recently). Share buybacks could also help to increase earnings per share.
However, given the balance sheet risks, there could be safer dividend stocks to consider buying. Looking at the recent share price action, institutional investors (the ‘smart money’) are clearly cautious here.
