By Michael McCarthy 

A low interest rate environment naturally has investors looking for opportunities to capture solid income streams. The dividend yield play has played an important role in Australian investors’ portfolios over the last four years. However, increasing bank capital requirements and lower commodity prices mean dividend yield assumptions are under examination. Are board members about to kill the golden goose?

It seems likely that BHP will cut its dividend at its results announcement on February 23. Both the chair and the CEO have stated clearly that the balance sheet takes priority over the dividend, and the progressive policy will be abandoned if the bottom line demands it. Similarly, regulators around the globe are lifting safety standards for banks, requiring higher capital buffers to support their activities. Retaining earnings by cutting dividends makes sense to all concerned.

However, this may give some investors a headache, especially where a steady income stream is highly desired. 

Luckily when it comes to dividend yields it’s all about numbers. There’s no need to gauge qualities like sentiment. Importantly, investors need to know what happens if dividend yields are cut. Let’s start by looking at the numbers:

Source: CMC Markets

The current dividend yield is calculated on the last two dividends paid by the company. In the table above, all dividends are fully franked. The table illustrates the impact of a cut in dividends – by 10%, 20% and 50%.

Cutting cash dividends

The plummet in commodity prices means both BHP and Rio could move on their dividends. The cyclical nature of the mining industry, and the large swings between highs and lows, explains why boards can slash and boost dividends. 

Many analyst expect earnings for these global miners to trough this year, and head higher over the coming years as commodity prices stabilise and the companies reap the benefits of cost cutting and reduced capital expenditure. If board members are less optimistic, or wish to take a more conservative approach, a 50% or greater cut in the cash value of the dividend is realistic. However, it’s important to note that even at 50% of current levels, the BHP dividend yield for Australian taxpayers is still above 7%! 

The potential for a 50% cut in bank dividend yields appears significantly lower, barring a local or international financial crisis (buy puts!). Most analysts are forecasting flat to slightly higher bank dividends. The table illustrates the impact of a cut by 10% or 20%. While somewhat reducing the case for the dividend yield, it by no means derails it. 

It’s not just a reduction in the cash dividend that investors should consider. The tax component is also important, with franking making up almost a third of the value of the dividend yield. No company profit means no tax, and no accumulated tax credits to distribute as franking. Once again this appears more material to BHP and Rio rather than the banks and Telstra. This effect is offset by the fact that the mining companies generally are holding tax credits associated with the boom year profits. In my view a fall in franking values independent of the cash value of dividends is unlikely.

Owning shares exposes investors to capital risks – share prices can go down as well as up. Investors should examine  dividend yields in light of this risk. It’s also worth bearing in mind that if a company announces a reduction in dividend, there could be a severe share price reaction. 

Investors must make their own decisions with individual circumstances in mind. However, for those with longer time horizons  the table above may provide a reason not to bail out of current holdings. Dividend yields are also an indicator of value. The lower dividend yield of CBA could see some investors taking profits and switching into one of the higher yielding banks. Whether to buy more shares at current prices is another question for individuals, and their advisors.