By David Brett
LONDON, Oct 10 (Reuters) - Having herded en masse into stocks that offered much higher yields than benchmark government bonds, investors are increasingly faced with a reality check on whether those returns are sustainable over any length of time.
Central banks success in driving government bond yields to rock bottom made it a no brainer over the past 2-3 years for investors to sink their money into a wide range of companies, all of which offered substantially higher returns.
But with the global economy recovering and monetary stimulus on the verge of being unwound in the United States at least, a rise in bond yields is making it clear that many of those companies may not be able to deliver.
In many cases, dividend cover, which measures the ability of firms to keep paying shareholders from profits earned, is falling as companies struggle to match the prospective rise in bond yields with stronger profits.
A search of stocks offering sustainable payouts at a rate better than yields on European government bonds would be reduced by a third if bond yields rise as forecast in a Reuters poll, which shows the 10-year German Bund yield at 2.30 percent in 12 months' time from around 1.86 percent on Thursday.
Top-rated analysts see STOXX Europe 600 third-quarter earnings per share falling 6.6 percent year-on-year, according to Thomson Reuters Starmine SmartEstimates data. For Britain's top 350 listed companies, dividend cover has dropped to a 3-year low of 1.4 times, from 2.3 times, according to stockbroker Share Centre.
Comparable research is not available for Europe, but the trend in earnings forecasts still leans towards downgrades.
'As bond yields rise back up to what might be considered more normal levels, investors are able to look at their exposure in income-paying equities and reappraise those where future dividend growth may be negligible or in the worst case, negative,' Dean Cook, investment analyst at Duncan Lawrie Private Bank, said.
'Should bonds offer a more compelling risk-adjusted income to those less-favoured equities, the natural result would be a move towards bonds. Of the remaining equity exposure, investors are likely to favour those stocks where dividends are growing annually, whilst maintaining a comfortable (dividend cover).'
Stephen Message, fund manager at Old Mutual, said companies where the starting yield is greater than the market and where there is scope for meaningful dividend growth in the future include insurer Legal & General, bank HSBC and satellite communications provider Inmarsat.
Analysts and investors often use proprietary models to pick the best dividend plays, with factors that can include above-inflation dividend growth forecasts and creditworthiness metrics, alongside above-average dividend cover.
There are 30 European blue chips with a dividend yield of greater than 3.25 percent - which is expected to be offered by UK gilts over the next 12 months, the highest yield among safer government bonds - a dividend cover of more than 1.4 times and which are in the top 25 percent of firms in their sector using Thomson Reuters StarMine's credit risk model.
That marks a slide of almost a third from the 43 companies which currently make it into the basket, based on the average expectation for gilt yields expressed in Reuters' previous poll.
Thirty percent of those falling out were industrials, 23 percent were in the consumer discretionary sector and 15 percent were from consumer staples and materials.
Of the stocks which are expected to maintain sustainable yields above 3.25 percent in the coming year, the industrials, consumer staples and consumer discretionary sectors each represent 17 percent of the basket but remain behind financials, which dominate with over 36 percent.
Among the financials to make it in are UK insurer Amlin , Legal & General and French reinsurer Scor.
While renowned for their often above-average dividend payouts, only one utility and one telecom stock feature in the basket, as they are seen as less sustainable in the long-term.
'It's important to avoid the dividend traps ... A yield of 9 or 10 percent usually tells you that trouble is coming, that the company's cash flow is not stable,' Oliver Pfeil, portfolio manager, global equities, at Deutsche Asset & Wealth Management, which has about 1 trillion euros ($1.35 trillion) in assets under management.
(Reporting by David Brett; Editing by Ruth Pitchford and Patrick Graham) Keywords: EUROPE MARKETS/DIVIDENDS
(firstname.lastname@example.org)(020 7542 8099)(Reuters Messaging: Reuters Messaging: email@example.com)
Copyright Thomson Reuters 2013. All rights reserved.
The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.