Make sure you don't pay the price...

MANY blue-chip stocks are stretching their dividend payouts to the limit, writes John Stepek, executive editor of MoneyWeek magazine.

UK investors are probably sick of hearing about equity income funds in the wake of the Neil Woodford debacle. But last week attention turned to traditional equity income funds, rather than Woodford's (which wasn't really an equity income fund at all).

The general point (and appeal) of an equity income fund is that it invests in companies that offer higher-than-average dividend yields, whereas Woodford's fund eventually owned large numbers of unlisted stocks paying no dividends at all, propped up by a few mid-cap high-yielders.

The good news is that most UK equity income funds you're likely to own are nothing like that. The bad news, as Laura Suter of investment platform AJ Bell points out, is that many funds are currently invested in stocks that appear to be pushing the limit when it comes to their payouts.

Dividend cover is a simple ratio that compares earnings with dividend payouts. Ideally, you'd want to see a dividend cover of twice or more – in other words, where earnings are at least twice as large as dividend payouts, providing a nice cushion in case of future disappointments.

However, dividend cover across the board has been steadily shrinking and is expected to hit its lowest level in a decade this year. The risk is that this will leave companies unable to maintain their payouts.

As Suter flags up, ten of the highest-yielding stocks in the FTSE 100 have dividend cover of less than 1.5 times. These include housebuilders Persimmon and Taylor Wimpey and tobacco giant Imperial Brands (all of which trade on extraordinarily high yields of above 11%), while both of the oil majors, BP and Shell (yielding a bit below 7% a piece), are also on the list.

In turn, says Suter, of the 83 funds in the UK Equity Income sector, a full 30 of them own five or more of these high-yielding "dangerzone" stocks in their top-ten holdings. Some of the biggest funds on the list include the Man GLG UK Income fund and the M&G Dividend fund.

Does low dividend cover mean a stock is heading for a dividend cut? Not necessarily. Companies with dependable earnings can operate with lower dividend cover than those with volatile earnings.

And with dividend yields above 11%, a fund manager may consider a stock worth buying in any case – even if the dividend is trimmed, it may still end up being reasonably generous.

However, if you are an income investor, look at the funds you own (and any individual stocks you have) to check just how dependent your income is on individual stocks. If your payouts are coming from just a handful of companies, you may want to diversify your portfolio further.