UK inflation is currently running well above the Bank of England’s 2% target rate. In the November reading, CPI inflation was at 5.1%. Even with the rate hike in December, a 0.15% increase isn’t going to stem inflation anytime soon. Therefore, one way we like to avoid the erosion of our cash funds is via investing in top dividend stocks.
Making sense of the dividend yield
When we buy a stock that pays out dividends, we can calculate the dividend yield. This is a ratio that looks at the dividend per share relative to the current share price. It can be expressed as a percentage. For example, if a stock has a share price of 100p and pays out an annual dividend of 10p, the dividend yield is 10%.
This percentage allows us to compare different income stocks with each other. It also allows us to compare other asset yields with each other. For example, if a bond is yielding 5%, a stock has a dividend yield of 5% and a Cash ISA has a yield of 1%, I can weigh up where I want to put my money.
However, we do note that this isn’t a perfect comparison. Bond coupons have to be paid, otherwise it’s classified as a default. With dividends, a company can freely cut or suspend a dividend. There’s no guarantee that the payout will be the same as last year – something we saw during the 2020 pandemic.
Using dividends to offset inflation
Now that we’ve got a grasp of how to use a dividend yield, we can use it to tackle inflation. The main aim here is to buy top dividend stocks with a yield higher than the current rate of inflation. Even though the FTSE 100 average dividend yield is 3.45%, there are plenty of individual stocks with yields higher than 5%.
In fact, there are stocks with yields above 10% that are worth considering. However, we’d prefer to go for lower risk names in the 5-8% yielding space. This is because yields above 10% usually aren’t sustainable.
For example, a yield that high could mean that the share price is falling rapidly. If the share price falls but the dividend remains the same, the yield gets artificially pushed higher. Yet the falling share price could be due to poor performance. This would probably lead to the dividend being cut at some point in the near future.
Even with this risk, it’s clear that I can get dividends that will allow me to offset the negative erosion of inflation.
Looking to 2022
Overall, we think that dividend income will become more of a focus for UK investors into 2022. With inflation likely to remain high for some time, picking up income from top dividend stocks is a viable option to help counteract this.
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