Various FTSE 100 companies appear to have discovered the secret to income alchemy by still producing dividend gold in the face of mounting economic pressures.

Half a dozen stocks in the UK blue chip stock market index are currently luring investors with double-digit dividend yields. Another 35 are forecast to pay shareholders more than FTSE 100’s 4.2% average yield.

While many dividend-paying shares come from defensive and less growth-focused sectors of the economy, a wider slowdown will inevitably have an impact on earnings and the ability of companies to pay those dividends.

One of the fundamental truths about investing is there is no such thing as a free lunch. A share that promises higher returns is going to come with higher risks of losing money, and the higher the dividend yield, the more likely that promised returns will prove illusionary.

WHICH STOCKS PAY THE MOST?

Let’s take a closer look at some of the FTSE 100’s largest yields, and there’s no better place to start than at the top. Housebuilder Persimmon (PSN) has a 16% dividend yield, based on this year’s forecast 235p payment.

On the face of it, Persimmon looks a safe bet. It has one of the highest operating profit margins in the housebuilding sector at 26.5% and its generous dividend has always been backed by surplus cash in recent years. But with storm clouds gathering over the UK economy, is this high dividend yield sustainable?

Last year its dividend cost about £750 million from £785 million of operating cash flow, so it is paying out more than 95% of its net profit as dividends. A payout ratio like this is not untypical for utility companies, whose customer spend is essential. That’s not the case for Persimmon and, traditionally, investors prefer non-utility companies to have the dividend covered 1.5-times or more by earnings, versus the company’s 2022 1.05-times.

FALLING DIVIDENDS?

According to Sharepad data, Persimmon’s dividends and earnings are set to decline in 2023 and 2024, but only modestly, with consensus projecting payouts of 228.9p and 227.7p respectively in the next two years.

This is also where its cash surplus comes in. Persimmon reported a cash balance of £780 million at the end of June, enough to cover a year’s dividend without any contribution from profits. The company also had £1.9 billion of forward sales on its books at the end of June, approximately six months’ revenue and profit.

This puts it in a strong financial position and certainly reduces any immediate risk of a dividend cut. That said, rising interest rates and cost of living pressures could see the end of two years of bumper house price growth when buyers binged on cheap credit. There are also regulatory headwinds, rising costs and labour issues which all threaten demand and profits. These concerns are weighing on housebuilders’ shares, and as investor selling has pushed stock prices lower, dividend yields have shot higher.

This means that Persimmon is not the only housebuilder seemingly offering fantastically high yields. Barratt Developments (BDEV) and Taylor Wimpey (TW.) may not have quite the same balance sheet strength of Persimmon but both still look robust enough to weather a housing crash, within reason.

The pair had net cash of £1.5 billion and £921 million respectively at the end of 2021, while free cash flow was 3.6 and 1.4 times dividends last year.

As Shares discussed in a sector feature on 25 Aug, the UK housing market is structurally undersupplied, and Persimmon and others are playing a big role in meeting the country’s housing targets. So, on balance, this could be a good time to buy Persimmon shares for the income, even if it feels counterintuitive.

DIGGING UP BIG DIVIDENDS

This is arguably not the case with Rio Tinto (RIO). The £79 billion mining giant is on a yield of 11.2%, based on this year’s forecast 516.7p payout. The problem is that commodity producers tend to be tied tightly to the global economic cycle, and with that starting to cool, investors are getting increasingly nervous about the company’s profit prospects.

Over the last decade, around 80% of Rio Tinto’s earnings came from iron ore, 10% from aluminium, 5% from copper and the last 5% from various other minerals and metals. Demand and pricing of commodities can be extremely volatile and that means Rio Tinto’s operating, financial and dividend records have been too.

For example, last year’s pre-tax profit of $30.8 billion was double 2020’s $15.4 billion, itself more than twice 2016’s $6.3 billion, while Rio plunged $726 million into the red in 2015. Dividends have been bolstered by five special payouts worth 479p per share since 2018, thanks to spells of significantly higher prices for its core iron ore, aluminium and copper products.

Looking ahead, analysts do not expect bumper commodity prices to last as economies around the world face slowdown and perhaps recession. Current forecasts already factor in a sharp fall in earnings for Rio Tinto, albeit a smoother decline for dividends. That said, analysts at investment bank Berenberg have recently been cautioning clients that the miner’s consensus dividend forecasts are too high. Investors will have to decide whether the current yield is worth the risk.

CAN YOU BANK ON NATWEST?

Alongside housebuilder and commodity equities, financials also appear to be offering very high yields, on paper anyway. High-street bank NatWest (NWG) is set to hand out more than £2 billion in dividends after beating analysts’ expectations in the second quarter and raising full-year guidance, despite growing economic uncertainty and pressures on household budgets intensifying.

Between mid-July and mid-August 2022, the share price rallied 25% as investors piled in after the lender reported second quarter pre-tax operating profit of £1.5 billion, 20% up on the previous year and well ahead of analysts’ expectations of £1 billion.

But investors should note that much of that financial performance was driven by mortgage growth as well as rising interest rates, which have boosted profits across the sector. As we discussed earlier, mortgage demand could quickly dry up in the months ahead, particularly as individuals stare into the abyss of surging bills to heat homes and keep the lights on this winter.

The counter argument, pitched by analysts at Jefferies, is that stubbornly sticky inflation will force the Bank of England to continue its policy of interest rate rises, creating a supportive environment for lenders.

According to Jefferies’ calculations, for every quarter point rise in interest rates NatWest’s net interest income experiences a 5.5% uplift. Money markets are already pricing several additional interest-rate rises this year, with rates peaking at 3.25% in 2023.

Yet analysts in general seem to be far more nervous about NatWest’s near-term profits and payouts. Consensus forecasts, according to Sharepad data, imply that NatWest will halve its shareholder payment in 2023, from this year’s 30.4p per share to 15.7p. If that proves correct, the bank’s 12% 2022 yield will fall to 6% or so next year, about where investors might expect bank yields to sit.

Experienced investors know the value of sustainable dividends capable of inching higher year after year, and it’s a well-worn path to long-term wealth creation. But are these dividends sustainable? That’s the question investors need to decide before buying any of the FTSE 100’s largest yields at present.

On balance, Persimmon probably, Rio possibly not. As for NatWest, both analysts and the wider market are saying no.

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