A Stocks and Shares ISA can be a source of passive income when invested in dividend shares. Rather than simply buying dividend shares I like, I could also focus on a certain target yield. For example, a 5% annual dividend yield on £20,000 worth of shares should hopefully earn me £1,000 a year in dividend income. In this example I will aim higher — for 6%. That should earn me £1,200 in annual dividend income, if the companies I buy maintain their dividends.
Setting a target yield
However, I do not start looking for companies by focusing on their dividend yield. Instead, I look for great companies trading at attractive prices. Only once I have found such a firm do I consider the dividend yield it offers me at the current share price.
One of the benefits of setting a target yield is it can push me to hunt more actively for companies that might not otherwise be on my radar. I could build a portfolio using familiar companies offering me a 3% yield, such as Burberry, WPP and B&M. But if I target a 6% average yield, I could double my returns – possibly by learning about companies I had not previously considered.
Managing my risks
Whatever shares I look at, I would stay inside my circle of competence. That way, I feel I am more likely to be able to judge a company and its attractiveness.
I would also diversify my Stocks and Shares ISA across a variety of different companies and business areas. Dividends are never guaranteed. By diversifying my portfolio, I reduce the impact on it if one of the companies I invest in cuts its dividend.
Crucially, I would seek to avoid the temptation of chasing yield for its own sake. The apparent appeal of this is understandable, but I think it can be dangerous. High yields often reflect high risks at a company. So, if I find a company yielding 6% when its industry peers typically offer a lower yield, I am best served by being honest with myself about risks the company faces. Does the 6% yield simply reflect the fact the company is overlooked or underappreciated by many investors, or is it a signal that a deterioration in the business could lead to the dividend being cut?
Some 6%+ yielding UK dividend shares I like
To target a 6% average dividend yield, not all of the shares that I invest in need to yield 6%. Some could offer me more, some less.
But in fact a number of companies I find attractive currently offer a 6% yield — or higher.
Two of them are tobacco manufacturers: British American Tobacco and Imperial Brands. The economics of the tobacco industry can lead to high dividends, as is the case right now at both of these UK companies. Cigarettes are cheap to make. But premium branding and strong customer demand can help sustain high profit margins. As there are limited opportunities for the companies to reinvest their profits in new business, they can pay them out as dividends.
One area in which both companies have been investing is developing non-cigarette product lines. As one of the key risks to the firms is a decline in cigarette smoking leading to revenues and profits falling, I think that makes good commercial sense.
Will it be enough to keep the dividends going at their current level far into the future? No-one knows. For now, the non-cigarette markets are growing but eating up a lot of marketing spend. So they are generally unprofitable, although hopefully that will change in future. British American expects its non-cigarette business to turn profitable in 2025, for example. I also think cigarette profits have been surprisingly resilient. Cigarette smoking rates in most markets have been declining for decades already. But due to global reach, including countries with slower rates of decline, and pricing power allowing them to push up what they sell their products for, both of these companies remain solidly profitable.
Financial services shares to buy now
Another three 6%+ yielding UK shares I would consider for my Stocks and Shares ISA are Legal & General, Abrdn and M&G.
They operate in a variety of areas. Legal & General is more focused on insurance and general and financial services, while Abrdn and M&G are in investment and asset management. What unites the three is an ability to pay juicy dividends. Like tobacco, that is mostly explained by the economics of their industry. A large number of clients pay substantial sums, so even a fairly small profit margin can add up to big profits.
In the case of Legal & General, underwriting skill can help boost that profit by pricing risks at the right level. For Abrdn and M&G, it can come in the shape of commission. What seems like a small commission in percentage terms can translate into a substantial cash profit.
All three also benefit from well-known brands with long-established reputations. Even the feebly named Abrdn has the prestigious brand Standard Life in its portfolio of assets. Such brands can help give the companies pricing power and encourage client loyalty. One risk to all financial services clients, though, is any economic downturn. That could lead clients to spend less and shop around more for services, hurting profit margins.
Yet over time, I expect all three firms could do well from owning strong brands in an industry with favourable economics. I would be happy to hold them in my Stocks and Shares ISA.
Putting my Stocks and Shares ISA plan into action
I already own four of these five shares in my ISA. Buying all five of them today, I could earn an average yield in excess of 6%, meaning I would hopefully earn £1,200 or more in annual dividends if I invested £20,000.
I would consider doing that in my portfolio, as I regard all five companies as having strong business prospects and attractive share prices.