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Should you go for the 5% dividend yield from the FTSE 100’s Severn Trent?

FTSE 100 water and wastewater company Severn Trent (LSE: SVT) has raised its dividend around 14% over the last five years. Meanwhile, the share price has risen around 9% over the period, although it did go higher but has eased back since last year.

At today’s share price close to 1,891p, the forward dividend yield runs a little over 5% for the trading year to March 2020. At first glance, the level of the yield and the relative stability of the stock’s performance appears to make the firm a decent, if unspectacular, candidate for a dividend-led investing strategy.

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The elephant in the room

I reckon the utilities sector is traditionally seen as fertile ground by dividend-hunting investors because of the perception that the underlying businesses of firms like Severn Trent are stable, defensive and cash-generating. And the company’s record of cash flow from operations is, indeed, consistent and easily covers earnings each year. But as with most utility companies, the elephant in the room is the gargantuan debt load. Developing, operating and maintaining water and waste infrastructure takes bucket-loads of cash, and much of the capital needed comes from borrowings in various forms.

In today’s half-year results report, Severn Trent reported its net debt at just over £5.4bn, which compares to last year’s operating profit of around £530m. Indeed, the numbers for revenue, costs and borrowings are large, and little shifts in those big numbers can produce big changes in the smaller figures for net profit and dividends. One of the biggest threats is that the firm is vulnerable to changes in the interest rates that are charged on its debt. We could be about to move into a higher interest rate environment with interest rates moving on a trend upwards. Yet Severn Trent has enjoyed a long period of very low interest rates, so it’s unclear how it will cope. If interest rates rise, there’s only so far that the incoming cash flow can go, and it’s possible that the dividend could become vulnerable to being slashed.

If this happens, all bets are off

We really don’t want to see a dividend cut because the share price will likely dive too. I see that scenario as a significant risk when holding shares in Severn Trent. The pace of dividend growth has been pedestrian, so there won’t be much fat to insulate you if the share price plunges, and capital losses could end up wiping out years’ worth of your dividend-income gains.

But regulatory pressure keeps the firm investing huge sums into its assets, and on top of that, there is a significant political risk on the horizon. If we see a future Labour government nationalise the sector, all bets are off for investor returns, in my view. However, things are ticking over well at the moment. For the first half of the trading year, revenue rose 3.6% year-on-year, and underlying earnings per share moved just over 16% higher. The directors demonstrated their optimism in the outlook by pushing up the interim dividend almost 8%.

I think Severn Trent looks like a decent dividend investment at the moment, but I’m wary of the risks inherent in a long-term holding period. So if I held the shares now, I’d remain vigilant.

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Kevin Godbold has no position in any of the shares 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.