Europe's Eye-Catching Dividends

By HESTER PLUMRIDGE

European equities may have bounced back over the past month as sovereign fears have eased. But all the major indices with the exception of Germany's DAX are still down since the start of the year. And with many companies announcing increased dividends during the current results season, many European stocks now offer juicy yields.

Average dividend yields on European stocks are now higher than those on government bonds for only the third time in 30 years. On the last two occasions, in early 2003 and 2009, that heralded a rally in equities. But although equity markets are below long-term price to book ratios, and European stocks have rallied in recent weeks, analysts are cautious about forecasting big gains, noting an uncertain growth outlook and lingering fears on sovereign debt. That is good news for income investors.

This year, European equities will yield 4.1%, estimates UBS, almost twice that of US peers. That's above the current yield on AA-rated corporate bonds (3.3%) and the coupon on a 10-year government bond for a weighted average of 11 euro-zone countries (3.6%). Unlike the latter two, dividend yields are well above their 10-year average.

True, dividends can be cut. Payments have been slashed some 40% since 2008, versus cuts of less than 30% in the last three recessions. The cancellation of BP's dividend in June took 12% off forecasts for U.K. companies' second-quarter payments, notes Capita Registrars. Corporate earnings could still disappoint: UBS forecasts of 24% European earnings growth in 2010 and 10% in 2011 compare with a 7% long-run average, and a contraction last year and in 2008.

But corporate cash balances are at or near all-time highs, and gearing at multiyear lows. Companies are slowly returning to the acquisition trail: July's M&A deal volume globally was the highest this year, notes Dealogic, with Europe leading the way. But dividend payments still look sustainable: dividend cover at 1.6 times free cash-flow is in line with a 10-year average, notes UBS.

And although dividend payments from banks, typically around a quarter of Europe's highest-yielding stocks, are still disappointing, the telecommunications, utilities and energy sectors are all yielding a respectable 5-6%, notes J.P. Morgan. Investors should take note.

Write to Hester Plumridge at Hester.Plumridge@dowjones.com