Schroders: Europe v UK: How safe is your yield?

With potential rate rises posing a challenge to markets, in a new infographic we look at we look at what drives the yields of UK and European markets and assess the safety of these income streams…..

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Sue Noffke, Head of Prime UK Equity Team

Rising rates heighten yield risk

Central bankers in the US and the UK have been preparing investors for the first rise in interest rates since they adopted looser monetary policy in the wake of the credit crisis to prevent a collapse of the financial system.

Equities, which have been among the greatest beneficiaries of the low interest rate environment, are heavily exposed to the risk of rate hikes.

Higher interest rates not only erode the value investors place on equity yield but they can also directly threaten the yield itself; a rise in interest rates can increase companies’ costs, reduce cashflow and earnings, all of which can impact their ability to pay a dividend yield.1

There is also the question of how global growth will be impacted by tightened monetary conditions. Concerns here were underlined by China’s currency devaluation in August, with fears it could be a precursor to a sharp slowdown in the world’s second-largest economy and emerging markets in general.

And the ramifications of the resulting sell-off in equity, commodity and energy prices are now being felt. Over the last three months dividend forecasts have been cut for 40% of Europe’s biggest companies exposed to China, according to financial information services firm Markit.

In a high-profile example, UK mining and trading company Glencore unveiled a number of cash-saving measures last week (7 September 2015), including suspending the dividend, to avoid losing its investment-grade credit rating.

This infographic visualises the drivers of the European and UK equity markets’ yields. Specifically, it illustrates 10 ‘yield groupings’, and the relative importance of the companies in them to the markets’ overall yields. It does this by showing the average market value (see right-hand Y axis) of the firms in each of the groups, which is important when analysing market-capitalisation weighted indices.

By the UK market, we refer to the FTSE All-Share index, and for Europe, MSCI EMU Europe, as it tracks the stockmarkets of the European Economic and Monetary Union’s 10 member states. These are both market-capitalisation-weighted indices, so the bigger companies have greater influence on their overall yields, which are presently 3.6% and 3.1% respectively (historic data).

It should come as no surprise to seasoned market watchers that the UK’s yield is driven by a few large companies – indeed only five large names generated 45% of all UK dividends in 2014.2

But the infographic goes one step further, by illustrating the proportion of firms in each yield grouping which have dividend cover3 of greater than 2.5 times (again, based on historic data). At a very simple level, the higher the proportion here (see left-hand Y axis), the safer are the dividends in the respective yield groupings.

The largest companies drive the UK stockmarket’s yield…

In the UK, while the yield is higher, and dividends marginally better covered by company earnings at the overall market level (see data in the infographic’s second section, under the yield-concentration graphics) the yield is concentrated in a few large corporates, where the cover is relatively low.

So, for instance, there are 18 companies with yields of 5.5% or more, and they have an average market value of £26 billion.

This yield grouping includes four of the UK’s five largest quoted companies: international integrated oil and gas groups Royal Dutch Shell and BP, global banking leader HSBC and world-leading pharmaceutical name GlaxoSmithKline – none of these four have dividend cover of more than 2.5 times (historic data).

Underlying the concentration of the UK equity market’s yield in the biggest companies, seven of its 10 largest companies (to the right of the ‘market yield’ line) have historic yields in excess of the market’s 3.6% overall yield, and again none of these names has cover of more than 2.5 times.

Among the biggest 10 UK quoted companies, only international banking group Barclays and domestic leader Lloyds Banking meet this requirement.

… to a greater extent than their counterparts in Europe

In Europe, while the market yield is lower overall (again, see data in the second section, under the yield-concentration graphics), it is driven to a lesser extent by the region’s largest corporates.

Exactly half of the market’s 10 largest companies are positioned to the right of the market yield line, albeit, in a similar story to the UK, none of these names have cover of more than 2.5 times.

There are 20 European companies which yield 5.5% or more, but the firms in this group have a lower average market capitalisation (£16 billion) relative to the other nine yield groupings, than is the case in the UK.

And this group only includes two of the market’s largest names, as opposed to four – global integrated oil and gas business Total and banking leader Banco Santander.

The data in the second section of the infographic also makes interesting comparisons between the markets’ valuations and overall level of indebtedness, by examining their respective price/earnings (PE) ratios4 and the proportion of companies in each market with ‘low’ net financial gearing5, defined as being net financial gearing of under 50% (based on historic data).

Finally, the last section shows the yield and dividend cover of the various industry groupings in each market. We will examine the differences here in more details in the fourth part of our income explainer series.

To download the infographic in full click the link at the bottom of the page.

1. DIVIDEND YIELD: the amount of money that a company is expected to pay out to a shareholder in dividends, expressed as a percentage of the current share price.

2. According to Capita’s UK Dividend Monitor Royal Dutch Shell, HSBC, BP, GlaxoSmithKline and Vodafone, respectively the UK’s first, second, third, fourth and sixth-largest quoted companies (as at 31/08/15) paid 45% of total dividends in 2014, or £43.5 billion, versus the market’s £97.4 billion (including special distributions).

3. DIVIDEND COVER: the number of times an organisation is capable of paying dividends to shareholders from the profits earned during an accounting period, commonly calculated by dividing dividends per share into earnings per share.

4. PE ratio: This is used to value a company’s shares. It is calculated by dividing the current market price by the earnings per share.

5. NET FINANCIAL GEARING: A ratio of a company’s level of long-term debt, minus its cash balances, compared to its equity capital.


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