Year to date, the Aviva (LSE: AV) share price has declined by around 5% excluding dividends. This decline has pushed the company’s dividend yield up to 6.8%, which is one of the most attractive distributions in the FTSE 100.
However, if you are thinking of buying into this income champion, there is one issue you need to consider first.
What is probably the biggest cloud hanging over the business today is its exposure to lifetime mortgages (LTM). Along with peer Legal & General, Aviva is the largest provider of these products in the UK.
LTMs allow older people to borrow against the value of their homes as a sort of brick and mortar annuity. Borrowers can receive a regular monthly income without having to make monthly repayments. Interest accrues on the balance, and the final total is not due until the last borrower leaves the home, sells it or dies.
Companies like Aviva love these products because they can charge hefty interest costs, which according to my research, can exceed 5% per annum.
However, the Prudential Regulation Authority (PRA) has recently started to question the viability of these products. Specifically, the regulator is worried that if house prices start to fall, Aviva and its peers will suddenly find that they’ve lent out more than they can recover.
As a result, the PRA has drafted a new set of rules for this market. Currently out for consultation, if introduced, the new rules could require Aviva and its peers to hold more capital against LTMs.
If the PRA does decide to act, Aviva’s dividend might be in trouble. Aviva has been splashing the cash over the past 12 months. At the beginning of 2018, the company announced that it had £2bn of spare cash to deploy throughout 2018. Of this, management has already used €500m to pay back expensive debt, and it is part way through a £600m share buy-back. Management also increased the interim dividend by 10% at the beginning of August.
Currently, the company can afford these distributions. At the end of 2017, Aviva had a Solvency II cover ratio of 198%, with a capital surplus of £12.2bn.
However, if the company is required to increase its capital reserves, this surplus could quickly evaporate. For example, City analysts believe that smaller peer Just Group, which is also a prevalent issuer of LTMs, could have to raise an additional £400m — around 25% of its shareholder equity — if rules change. The total size of the market is £20bn and growing. Just has around £6.8bn of LTM products on its balance sheet.
Aviva reportedly has a larger market share of the LTM business than Just, but the business is more diversified. Still, I estimate any change in capital requirements could result in the company having to hold billions in additional funds.
Looking at Aviva’s balance sheet right now, I think the company can probably take a multi-billion pound hit without having to cut its dividend, although this is just an estimate.
We don’t know precisely how much additional capital the PRA will require Aviva to hold at this stage.
Overall then, Aviva’s dividend looks safe for the time being, but I wouldn’t rule out a small cut if the PRA decides to bring in strict LTM rules.
Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.