Unraveling dividend yields

I hope you’re enjoying the summer. Personally, I’m having a good one. In my opinion, it’s the sign of a fine summer if we’re all wishing for rain – and the back lawn looks like something from sub-Saharan Africa.

I don’t know about you, but high summer doesn’t make me feel like dwelling on my long-term investment prospects. But with current low interest rates and uncomfortable inflation numbers, it’s an issue that needs consideration – and regular re-evaluation.

The pay out

Worried about poor returns, many investors have been looking for capital growth from dividend yields, and have been selecting shares according to these payouts.

Dividends are simply how a company distributes a portion of its earnings to its shareholders – these are paid out in the form of cash or stocks.

FTSE 100 companies account for the bulk of these payouts, with the big payers being AstraZeneca, yielding 5%; GlaxoSmithKline 5.5%, BAT 5.1%, Vodafone 6.7% and Centrica 4.4%.

FTSE 250 companies and small-cap firms are less likely to pay out substantial dividends – preferring to reinvest their profits and grow the business.

Dividends are usually paid quarterly or every six months (and are taxable). Once a dividend has been paid, the share price is marked “ex-dividend” and the price will usually fall in accordance with the value of that payout. The value of the share will rise again as the next dividend yield approaches.

“The BP effect”

This week we’ve been told that UK shareholders’ dividends will fall by 6.5% in 2010 to a combined £54.7bn.

It sounds like a bleak outcome for those of us who are desperately trying to eek a little more from our long-term buy-and-hold positions. But all is not as dark as it seems …

These figures have been considerably distorted by the “BP effect”.

BP’s decision to suspend dividend payouts is estimated to have cost shareholders £5.4bn this year. Once this is accounted for, the trend for UK dividends becomes a positive one.

However, BP has taught us a valuable lesson about putting all our dividend expectations in one basket. Yes, the companies that pay dividends are the big, “safe” institutions – but the events in the Gulf of Mexico show that size does not equal safety. Just as you would with any other investment – spread your risk.

In a bid to do just this, many investors are looking for dividend yields overseas. If you do this, be sure to keep an eye on what the currency markets are doing.

What about the day trader?

This is all well and good for our long-term positions, but what kind of effect can these dividend payments have on our short-term trading?

It is a common misconception that spread betters don’t get a look-in on dividends. The reality is – as ever – rather more complicated than that.

Strictly speaking, spread betters don’t get dividend payments. When you hold a long spread-bet position on a company, you don’t actually own those shares, so you’re not entitled to the dividend.

However, what the spread better can get is a “dividend adjustment”.

If the spread bet doesn’t represent owning real shares – where does this money come from?

The hedge

In principle, when you take out a spread-bet position, the spread-bet company will then go into the real market and take out a corresponding position in real stocks and shares.

So, if you BUY Vodafone on a spread-bet platform – your spread-bet company will go into the market and buy Vodafone shares. In that way, they’re not taking on a risk from your position, and are simply making their profit from the spread and financing charges.

However, while some spread-bet companies hedge 100% of their business, many don’t work like this. In reality, it comes down to the individual approach of each company, and how they choose to balance the risk posed by your trades.

However, the underlying principle remains – that your spread bet represents the buying or selling of shares in the real market. Which is where dividends come in …

Swings and roundabouts

So, if you’re LONG on Vodafone with a rolling daily bet, and they pay out a dividend – you’ll be paid the value of that dividend. (Well, you’ll actually get 80% of its value, because, unlike spread betting, dividends are taxable.)

Conversely, if you’re SHORT on Vodafone with a rolling daily bet, and a dividend is paid out – you’ll be debited the value of that dividend – all 100% of it.

However, if you’re looking at short-term daily positions, the dividend has little effect, as the value of your share will go down once the dividend is paid – if you’re LONG, this works against you; if you’re SHORT, it works in your favour.

Your net outcome is relatively unchanged (except that you’ve been charged 20% “tax” on your dividend adjustment).

I put the word “tax” in inverted commas because these aren’t real dividends – they’re dividend adjustments. So you’re actually paying this 20% to the spread-bet company rather than the taxman.

Spread-bet companies creaming a bit off for themselves – surprise, surprise!

Beware discounted futures

So, if dividends don’t do much for the day trader – what about quarterly or futures bets?

Different spread-bet companies deal with these differently.

Some companies work in exactly the same way as with rolling daily bets.

Others build the dividend into the futures price.

What does this mean?

Well, let’s say that I’m buying a futures contract in (to use our example again) – Vodafone. Within the period of that contract, a dividend payment is due. Rather than pay out that dividend to me when it becomes due, the spread-bet company offer me a discounted price on the contract now.

That means that the Vodafone futures price will be cheaper than the Vodafone cash price (because the dividend is already worked in, in the form of a discount).

However, come the date of the actual dividend payment, there may be a further adjustment made to your account – if the actual dividend turns out to be different to the predicted dividend yield.

So, next time you hear someone stating categorically that spread betters don’t get paid dividends – you’ll be able to put them right.

Related posts:

Dividend capture – old-fashioned investing gets a face lift These payouts have risen by 60% in the last 5 years