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I FTSE 100 it is full of dividend paying stocks. But right now, three insurance giants stand out from the crowd.
Legal & General (LSE: LGEN), Ordinary Life (LSE:SDLF), and IM&G (LSE:MNG) currently outperforms the UK flagship index at 8.4%, 7.7%, and 6.7% respectively.
So should investors rush to take advantage? Or are these sweet deals too good to be true?
A rare building tailwind
Legal & General specializes in asset management and retirement products. Standard Life (known as the Phoenix Group) also focuses on retirement, but also life insurance. And M&G is another asset management firm with a life insurance component.
However, although there are significant differences in strategy and products, all three companies benefit from the same structural approach – the UK retirement crisis.
With the boomer generation entering retirement and the UK State Pension falling far short of what is needed to live comfortably, the trio are keen to provide solutions. And with rising interest rates emerging at the same time, demand for pension funds is growing for both retirees and businesses looking to strengthen their pension plans.
The perfect timing of these storms has created a booming economy for these businesses, with the proceeds of bulk purchases helping to bolster profits while at the same time attracting incredible cash flow from new customers. And since most dividends are covered by cash generation, good yields look like they’re here to stay.
But if that’s the case, why aren’t many investors taking advantage of this seemingly amazing income opportunity?
Long term storms
The situation is complicated. But to put things simply, the increase in demand for annuities has not been seen. And it seems like the entire insurance industry is trying to work around this goal, leading to an extreme level of competition, even among these three stocks.
With so many options for customers to choose from, insurance groups are forced to price competitively, squeezing margins. But this pressure is only increased by the interest rate cut by the Bank of England (BoE).
Since annuities are priced at the yield of government bonds, lower interest rates put more downward pressure on the price. But it also presents the risk of replanting.
When older, higher-interest-paying bonds mature, these insurance companies are forced to reinvest their funds into newer, lower-interest bonds. As the interest on these bonds ends up paying guaranteed pension payments, it becomes harder for insurance groups to stay afloat and lowers profits even more.
But what does all this mean for investors right now?
An important point
While earnings from Legal & General, Standard Life, and M&G appear strong at the moment, there are growing concerns that this positive picture could gradually deteriorate over the next 12-18 months as the BoE continues its interest rate reduction programme.
Management teams at all three businesses have begun exploring alternative investments, particularly in the private debt markets, to offset the impact of falling government bond yields.
But even though they are very profitable, the private debt markets come with additional risk. And the high yields offered by these stocks are a reflection of that risk. And it’s something investors need to consider carefully before putting any money into action.
Personally, I think there are more attractive dividend opportunities to explore elsewhere.
