Investors should be cautious with the FTSE 100 when looking for sustainable income, says Quilter's Bradshaw

Investors should be aware of the pitfalls of investing solely in the FTSE 100 if they are wishing to generate a sustainable income stream, Quilter Investors’ Helen Bradshaw has warned.

With traditional income-providing asset classes, such as bonds, continuing to provide little yield, investors have come to rely on dividends from equity markets in order to generate an income.

The FTSE 100 has been a stalwart of income strategies thanks to its long history of generous dividend yields, currently standing at 4.65 per cent. However, Bradshaw, a portfolio manager, believes investors would be mistaken to think this is a fool proof way of investing for income.

“A decade of ultra-low interest rates has pushed bond yields off a cliff and resulted in a forced migration by income investors into more volatile equities,” Bradshaw says. “Although equity dividend levels in the UK have held up well, it is a mistake to assume they are immune from volatility.

“Thanks to different accounting periods and special dividends there’s little rhyme or reason to when companies in the same index choose to pay their dividends. This is especially true for the FTSE 100, where not only are dividends lumpy, but there are other issues to be aware of such as the concentration of dividends to just a handful of companies, as well as dividend cover.

“This is not to say the FTSE 100 doesn’t play a crucial role in income strategies, far from it. However, investors need to be broadening their horizons and diversifying their income streams. Other geographical regions offer attractive yields as well as the opportunity for dividend growth, such as emerging markets, while alternative asset classes such as infrastructure can provide increased diversification, alongside attractive yields.”

To illustrate the risks of relying on just a single asset class or geographic market, Bradshaw has highlighted the five issues currently facing the FTSE 100 when it comes to dividends –

Concentration risk – Today just shy of two-thirds of the dividends paid out by ‘UK plc’ derive from just 15 companies. The oil and gas sector dominates the picture accounting for around 17 per cent of UK dividends, with the mining and the banking sectors not far behind with each accounting for 14 per cent. The miners now account for GBP1 in every GBP7 paid out in dividends in 2019, this is an increase from GBP1 in every GBP9 in 2018.

Dividend cover – a measure of how well each company can afford to meet its dividend payments – looks worryingly thin in places, especially among the country’s 10 biggest dividend stocks. Currently, on average, this stands at just over one times earnings, low in historical standards.

Dividend growth – The UK has a well-established culture of sizable dividend payments, meaning very few are in a position to grow their dividend payments as economic factors begin to bite. Indeed, with less emphasis on special dividends, FTSE 100 dividend growth looks set to be the slowest for a decade in 2020, highlighting other geographical regions’ more attractive possibilities.

Currency risk – Other problems include the fact that many of the UK’s biggest dividend payers – such as BP and HSBC – pay their dividends in dollars. This introduces currency risk to as much as 40 per cent of the total dividends from the FTSE 100. Investors may not be aware of the risk currency movements can have on a portfolio, but with many of these large companies also making a large portion of their earnings in dollars, portfolios could be hit with a double whammy should the pound appreciate.

Lumpy dividends – Because UK companies generally pay their dividends in two instalments each year (not including any special dividends) and with the timings of these payments varying from company to company, the income stream from the UK stock market is as bumpy as a country road. This is one of the reasons why investors often find it difficult to find products that provide a regular monthly income, with less than 8 per cent of multi-asset funds providing investors with monthly income.