But beware focussing entirely on yield for returns.

Income from assets is an important part of overall returns, especially so in a lower interest rate environment and for investors who are partly or wholly dependent on their investments for their living expenses. The Australian sharemarket is known globally for its higher dividend yield and many local investors take advantage of this.

However, the risks involved in focusing entirely on dividend yield are sometimes overlooked in the rush for income.

There are structural reasons for the higher dividends payed by Australian listed companies. A key driver is the beneficial tax treatment known as dividend imputation. This is a recognition that companies pay dividends from after-tax profits. The imputation of these tax credits avoids taxing the same profits twice – once at the company level and again in the hands of shareholders.

When first introduced by the Hawke Government in the 1990s, the franking credits attached to dividends could only be offset against other tax liabilities of the shareholder. Shareholders who paid no tax received no additional benefits from franking credits.

In recognition of the importance of retirement savings, the Howard Government extended the benefit by allowing cash refunds of franking credits above any tax offset.

It is this measure that is under threat at the next federal election. The Labor Party has flagged that if elected it will disallow the cash refund of excess franking credits for certain groups of shareholders. Naturally, when the goalposts move, the players change their game.

This indicated change has seen many companies increase their dividends and/or pay special dividends for the most recent half or full year. A record $86 billion flowed back to shareholders.

This fact must be considered when assessing the dividend yield of Australian companies. The one-off nature of many of these payments means the current yield must be carefully considered by investors, as it may represent a high point.

Yield opportunities

Nonetheless, there are many attractive dividend yields from companies that form the top 200 index. (Investors generally focus on the larger listed stocks as they may offer greater certainty of earnings).

An assessment at the end of the first quarter of calendar 2019 reveals dividend yields for the top 200 stocks vary from zero to 21.5 per cent.

(Editor’s note: an unusually high dividend yield could be the result of a falling share price or reflect the risk that the company’s next dividend might be cut. Do extra research on stocks with very high yields, to avoid ‘dividend traps’.)

In this discussion, all yields are estimates based on the dividends paid over the past 12 months, excluding special dividends and franking credits. In other words, ordinary cash dividends for the coming year.

The direct relationship between risk and reward also applies to dividends. A lower share price results in a higher dividend yield. Higher returns from a company can be an indication of higher risk. That is, investors overall require higher income returns to compensate for a higher level of risk in holding that share.

Given the well-known issues affecting the financial sector, it should come as no surprise that 11 of the top 30 dividend yields are financial stocks, including all the big four banks.

Long-term Telstra shareholders are familiar with the challenges of dividends. Shareholders stick with a company despite a cloudy outlook because it is a stock that pays higher dividend. The share price slumps, but the shareholders hang in. Then dividends are cut, destroying the rationale for holding the stock.

This is a key risk for investors and a strong argument against comparing share dividend yields to fixed-term deposits and bonds. The capital risks in share investing are significant, although this risk can be positive as well as negative.

Investors with confidence in the long-term outlook for a business and who are investing over a longer timeframe may still decide to ride out any shorter-term share price fluctuations. Where there is a need in the short to medium term to realise the investment, extra care should be taken when contemplating dividend yields.

Possible franking changes

(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this story).

If the treatment of franking credits is changed, the real estate sector is a potential winner. Most real estate investment vehicles are trusts that pay no tax. There are no franking credits attached to their distributions, currently putting them at a disadvantage when compared to company dividends.

The sector rally to 10-year highs suggest investors are placing value on the higher cash component of Australian Real Estate Investment Trust (AREIT) income.

Income considerations play a role in investment decisions at any time of the market cycle. However, they receive much more weight in time of lower interest rates. Now, there is much speculation that interest rates may fall again, rather than rise, and the focus on dividends will probably remain intense while this is the case.

However, there is a longer-term risk. Buying shares for income is a crowded trade and when the interest rate cycle turns, the stampede could inflict severe damage.

The answer for many investors is to employ one of the most powerful risk management tools available: diversification. Diversifying within income-generating investments of a portfolio, as well as into assets with other dominant characteristics, can allow investors to create a portfolio that generates reasonable income and is potentially more capital stable.