When dividend yields rise above 6%, it’s usually wise to be cautious. Such high yields are often a warning that a dividend cut is likely.
But ignoring this rule of thumb can sometimes be very profitable. Sometimes Mr Market gives us the chance to lock in a high yield with very little risk.
I don’t expect a cut
A good example is HSBC Holdings (LSE: HSBA), which currently has a forecast yield of 7.5%. HSBC’s share price hardly moved following last week’s Brexit vote and the shares ended the week broadly unchanged.
This leaves the bank’s shares at their lowest level since March 2009, when many investors thought the whole global financial system might collapse. Are things really that bad now? I’m not convinced.
Over the last five years, banking regulation has become much tougher. UK banks such as HSBC now have much stronger balance sheets than they did heading into the financial crisis. A large part of HSBC’s profits come from Asia, so the UK’s decision to leave the EU should have a limited impact.
Analysts are forecasting a dividend of $0.40 per share this year, which should be covered 1.2 times by forecast earnings of $0.60 per share. I’d welcome a higher level of cover, but as things stand I don’t think a dividend cut is likely.
In my view HSBC remains a good income buy.
This one might be a sell
I’m less convinced about the case for investing in outsourcing firm Interserve (LSE: IRV). The firm warned in May that it faced a £70m exceptional cash cost from a troublesome contract. To put this in context, Interserve’s after-tax profit last year was just £68.9m.
The shares plummeted and now trade on just 4.3 times 2016 forecast earnings. Current forecasts suggest Interserve will pay a dividend of 25p this year, which equates to a staggering yield of 8.9%!
These extreme figures make it clear that the market is expecting further bad news. I agree. I think that a profit warning and a dividend cut are likely at some point this year.
In my view, the risks outweigh the potential reward from Interserve. I’d steer clear, at least until after the firm publishes its interim results in August.
A special situation?
Indian oil and mining firm Vedanta Resources (LSE: VED) is a more unusual high-yield choice. Although Vedanta halved its dividend payout in 2015/16, analysts are pencilling-in a 44% increase this year, giving the shares a prospective yield of 7.6%.
However, the latest consensus forecasts suggest that the payout may be cut again in 2017/18. So the picture isn’t very clear. I suspect that a more modest increase this year is more likely.
This is because while Vedanta does generate a lot of free cash flow — $1.7bn last year — most of this is needed to reduce the group’s debt. Vedanta’s net debt was $7,329m at the end of March, which is uncomfortably high given weak commodity prices.
Using last year’s dividend payout of $0.30 per share as a guide, I think a dividend payout of around $0.35 is more likely this year. This would give a yield of 6.3% at a share price of 400p.
I think Vedanta could be a profitable buy, but there are safer choices elsewhere in the mining sector.
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Roland Head owns shares of HSBC Holdings. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.