How safe are dividend yields at HSBC Holdings plc (7.8%) and Legal & General Group plc (7.3%)?

In today’s low-interest-rate world, stocks seem to have become the new bonds. As bond yields plunge to record lows, or in some cases into negative territory (at the last count $12trn bonds around the world supported negative yields), investors are increasingly looking to stocks with bond-like qualities to boost their portfolio’s income.

HSBC (LSE: HSBA) and Legal & General (LSE: LGEN) are two such companies. The shares of these financial giants support dividend yields in the high-single-digits, offering income investors a deal that’s hard to refuse.

However, if a company’s dividend yield exceeds the market average by a wide margin, it’s clear the market doesn’t trust the payout. In other words, the market doesn’t believe the payout is sustainable, and the higher than average yield reflects that.

Can the payouts be trusted?

According to City forecasts, shares in Legal & General will support a dividend yield of 7.3% this year while shares in HSBC currently support a dividend yield of 7.8%. Both of these yields are significantly above the market average. At close on Thursday the FTSE 100 supported an average dividend yield of 3.7%.

So, are these dividends here to stay for the long term? 

A quick back of the envelope calculation shows that Legal & General’s payout is the most sustainable of the two. The payout is covered 1.4 times by earnings per share and since the financial crisis, the company has adopted a dividend policy of only increasing the payout by as much as it can afford.

Moreover, due to the long-term nature of Legal & General’s business, the company has a significant degree of clarity over its future cash flows. The revenue from managing pensions and savings accounts can produce a steady, predictable stream of income for many years. Therefore, the predictability of Legal & General’s business means that management can set the level of the firm’s dividend with a degree of certainty that the payout is sustainable at that level. 

Put simply, if Legal & General’s management has done its job properly, the company’s dividend payout should be sustainable for the foreseeable future.

Uncertain outlook

On the other hand, the outlook for HSBC’s dividend is much more uncertain. 

City analysts expect the bank’s earnings per share to fall by 12% this year, reducing dividend cover to 1.2 times. What’s more, a worrying trend has developed in HSBC’s earnings and dividend payouts since the financial crisis. 

Specifically, since 2011 the bank’s earnings per share have fallen by just under 40%, (at current exchange rates). However, over the same period HSBC’s per-share dividend payout has increased by 16%. Dividend cover has decreased from 2.2. If this trend continues, it’s evident HSBC will have trouble maintaining its dividend payout. 

Also, investors need to consider the headwinds the global banking sector is currently facing. With economic growth slowing, interest rates falling and competition increasing, HSBC is going to find it difficult to grow earnings in such a hostile environment, which could pile pressure on the dividend. 

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Rupert Hargreaves has no position in any shares mentioned. 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.