From David Stevenson, across the river from the City

Dear Money Morning Reader,

It’s getting harder to generate a decent, relatively safe income from stocks. On the one hand, share prices have risen sharply from their March lows, driving down yields. On the other, the threat of cuts to dividend payouts hasn’t gone away.

Fears over a double-dip recession mean that a question mark still hangs over many payouts, particularly once all the cost-cutting’s done and companies are left hoping for rising sales that may not appear.

So what can you do if you rely on a dividend income? Here are some suggestions...

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Further dividend cuts look likely next year

The London stock market enjoyed a massive 21% rise in this year’s third quarter. But not everyone’s happy. “These are difficult times for investors in UK equity income funds”, says Jeff Prestridge of thisismoney.co.uk. “Fund managers are battling against dividend cuts”.

According to Markit, 2009’s first half saw just 55% of FTSE firms raise their dividends, against 80% the year before. Meanwhile, 16% cut their payouts and 12% axed them completely. For the full year, the overall payout level looks set to drop by 11%.

2010 might see a slight pick-up, reckons Markit – but don’t get too optimistic. The next government, regardless of its hue, will face still-lengthening dole queues and a state budget deficit that needs tackling. That means higher taxes and lower public spending.

If the economy starts to look groggy again next year as a result, and company cash flows come under pressure, corporate treasurers will have no option but to cut payments to shareholders.

What’s more, there’s the thorny issue of companies’ pension fund deficits. This particular black hole has shrunk a bit on the back of the stock market rally. But pension funds are still vulnerable to a pullback in share prices. Further, the recent drop in bond yields is actually bad news. Lower bond returns mean more money is needed by the funds to pay future liabilities, which increases the deficits again.

Things could get nasty if you're reliant on dividend income

Why does this matter? Because a company’s obligations to its pensioners rank above any requirement to pay dividends to shareholders. So if the pension deficit looks like getting out of hand, the shareholders take the pain in the form of smaller dividends.

Already prices paid in the ‘dividend swap market’ – where you can buy and sell future dividends for cash – show that investors expect payouts to end up being lower than the market is currently pricing in.

In short, it could all get rather nasty if you’re reliant on a UK dividend income stream. Newton fund manager Tineke Frikkee warns that distributions made by UK equity income funds could plunge by the end of this year and that FTSE yield data could be overstating eventual payouts.

“The most extreme example was last November when severe market weakness drove the yield on the FTSE All-Share to a 28-year high of 6.11%”, she says. “A week later, when the dividend cuts made by the UK banks were factored in, the FTSE All-Share yield dropped to 4.7%. Since then, further dividend cuts and rights issues, coupled with strong price performance, have pushed the market's yield down to 3.5%. So in December, those managers who don’t adjust their portfolios could face a serious hit to the dividends they collect”.

Joe Wiggins at Principal Investment Management agrees. “We’ve seen some funds chasing capital growth over dividends, and they’ll be the ones who’ll have to make changes, rather than the more defensive offerings from the likes of Frikkee and Neil Woodford [of Invesco Perpetual]”, he says. “I think the [payout] falls will be disparate, with some around 20-25%”.

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How you can protect your dividend income

In the longer run, we believe oil prices will go a lot higher. So unless a cut in the dividend would be a disaster for your portfolio, we’d be inclined to stick with the majors for now. However, if you bought in earlier this year, you should have a decent profit on the big oil stocks, so if you’d rather err on the side of caution, you could lock in some or all of those now.

The threat hanging over dividends is yet another good reason to diversify your portfolio.  Jonathan Miller of Citywire suggests taking a global view of income seeking. He likes the Newton Global Higher Income fund. Manager James Harries has run the £650m fund since its launch in November 2005, “returning 26.1% against 7% for the FTSE World Total Return index. The yield has increased each year and is currently 5.6% on a historical basis” – not bad at all by today’s standards.

Until next week,

David Stevenson
Associate editor, MoneyWeek UK

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Turning to the markets...

The JSE all share index traded flat closing up 0.16% yesterday. The gold mining index edged 0.86% higher. Resources inched up 0.13%. Banks and financials gained 1.53% and 1.07% respectively. Industrials eased 0.28% and the platinum mining index firmed 0.58%.

London’s FTSE100 closed down 1.08%. The Dow Jones lost 0.15% and the Nasdaq traded flat, gaining 0.04%.

Tokyo’s Nikkei closed 0.38% down. Hong Kong’s Hang Seng jumped 1.36%.

Brent crude is currently trading at $73.13 per barrel.

Spot gold’s trading at $1,068.31 and platinum was last quoted at $1,360.00.

And here’s how the rand is performing against the major currencies:
R/$7.31
R/£11.67
R/€10.88

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