The UK is well-known for its dividend-paying culture, whereby many companies listed on the London Stock Market pay money each year to shareholders.
The funds that specifically seek to invest in companies paying those dividends are called UK equity income funds. They are popular choices for investors who want to draw income, but are also often used by growth investors who can reinvest the income back into the fund to grow their money.
However, there is a danger we are relying on just a handful of companies to provide us with dividend income. This is because the top five dividend-paying companies account for 38%* of total dividends paid and the top 15 companies account for 58%*. It's all well and good as long they continue to pay up, but what happens if they stop?
Dividend cuts can be painful
A company's ability to pay a dividend is measured by what we call 'dividend cover'. Worryingly, recent analysis shows that dividend cover for the UK's largest 100 companies (FTSE 100) is at its lowest level since 2009**.
Looking back at this period, it is plain to see how painful dividend cuts can be. Banks and other financial companies paid £8.6 billion* worth of dividends in the second quarter of 2008, but this had fallen by more than 50% the following year*, as the global financial crisis took hold and payments stopped altogether.
The good news is that dividends aren't just a UK phenomenon – investors can also get dividend income from overseas companies. Here the picture is better: global dividends hit an all-time quarterly record high of US$447.5 billion*** in the three months to the end of June 2017.
According to the latest Global Dividend Index from Janus Henderson, dividend payments were up 5.4% year-on-year in US dollar terms and underlying growth was 7.2% - the fastest rate since late 2015. New quarterly records were recorded in Belgium, Indonesia, Japan, Netherlands, South Korea, Switzerland, and the US.
The weak pound
We usually only think about currency exchange rates when it comes to planning our holidays. However, exchange rates can also have an impact on our investments. Given the extreme weakness of sterling since the EU referendum and strength of both the US dollar and euro, it’s worth a mention.
For example, if you invest in a US company the returns you will ultimately receive will be influenced by movements in the sterling/dollar exchange rate. If sterling weakens against the dollar (as we have seen in recent months), your returns will be enhanced when your investment is converted back into sterling. If the company pays a dividend, this will also be worth more when paid to you in sterling.
Many UK companies, especially the larger ones in the FTSE 100, get a significant amount of revenue from abroad and pay dividends in dollars and euros. These dividends too will have increased in value once converted back into sterling since the Brexit vote.
If the reverse occurs, and sterling strengthens significantly against the dollar or euro, the UK's larger companies - where dividend cover is already looking stretched - could struggle to make their payments and global investors may see their dividends fall.
Time to hedge your bets?
Some funds have currency-hedged share classes. In this type of share class, currency fluctuations are lowered by using financial instruments called derivatives, so that any future exchange rate movements do not materially affect the level of the fund.
There are not many equity income funds with this facility, but two that I like that do have it are BlackRock Continental European Income and Investec Global Quality Equity Income. That said, over the long term, currency fluctuations tend to be ironed out, which is why many global fund managers don't offer hedged share classes. If you are willing to accept the slightly higher-than-usual currency risk, other global equity income funds worth considering include Artemis Global Income****, Guinness Global Equity Income, and Murray International**** investment trust.
*Capita UK Dividend Monitor issues 28 and 30
**The Share Centre, 3 July 2017
***Janus Henderson Global Dividend Index
**** Members of Moneywise’s First 50 Funds for beginner investors
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Mr McDermott’s views are his own and do not constitute financial advice.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre.