* Fewer dividend gems as bond yields rise, profits lag
* Just 30/600 Europe stocks to beat gilt yield in 12 months
* Results season may trim options more if results underwhelm
* Financials make up a third of Reuters basket of picks
By David Brett
LONDON, Oct 10 (Reuters) - Having herded en masse intostocks that offered much higher yields than benchmark governmentbonds, investors are increasingly faced with a reality check onwhether those returns are sustainable over any length of time.
Central banks success in driving government bond yields torock bottom made it a no brainer over the past 2-3 years forinvestors to sink their money into a wide range of companies,all of which offered substantially higher returns.
But with the global economy recovering and monetary stimuluson the verge of being unwound in the United States at least, arise in bond yields is making it clear that many of thosecompanies may not be able to deliver.
In many cases, dividend cover, which measures the ability offirms to keep paying shareholders from profits earned, isfalling as companies struggle to match the prospective rise inbond yields with stronger profits.
A search of stocks offering sustainable payouts at a ratebetter than yields on European government bonds would be reducedby a third if bond yields rise as forecast in a Reuters poll,which shows the 10-year German Bund yield at 2.30 percent in 12months' time from around 1.86 percent on Thursday.
Top-rated analysts see STOXX Europe 600 third-quarterearnings per share falling 6.6 percent year-on-year, accordingto Thomson Reuters Starmine SmartEstimates data. For Britain's top 350 listed companies, dividend cover hasdropped to a 3-year low of 1.4 times, from 2.3 times, accordingto stockbroker Share Centre.
Comparable research is not available for Europe, but thetrend in earnings forecasts still leans towards downgrades.
"As bond yields rise back up to what might be consideredmore normal levels, investors are able to look at their exposurein income-paying equities and reappraise those where futuredividend growth may be negligible or in the worst case,negative," Dean Cook, investment analyst at Duncan LawriePrivate Bank, said.
"Should bonds offer a more compelling risk-adjusted incometo those less-favoured equities, the natural result would be amove towards bonds. Of the remaining equity exposure, investorsare likely to favour those stocks where dividends are growingannually, whilst maintaining a comfortable (dividend cover)."
STOCK PICKS
Stephen Message, fund manager at Old Mutual, said companieswhere the starting yield is greater than the market and wherethere is scope for meaningful dividend growth in the futureinclude insurer Legal & General, bank HSBC andsatellite communications provider Inmarsat.
Analysts and investors often use proprietary models to pickthe best dividend plays, with factors that can includeabove-inflation dividend growth forecasts and creditworthinessmetrics, alongside above-average dividend cover.
There are 30 European blue chips with a dividend yield ofgreater than 3.25 percent - which is expected to be offered byUK gilts over the next 12 months, the highest yield among safergovernment bonds - a dividend cover of more than 1.4 times andwhich are in the top 25 percent of firms in their sector usingThomson Reuters StarMine's credit risk model.
That marks a slide of almost a third from the 43 companieswhich currently make it into the basket, based on the averageexpectation for gilt yields expressed in Reuters' previous poll.
Thirty percent of those falling out were industrials, 23percent were in the consumer discretionary sector and 15 percentwere from consumer staples and materials.
Of the stocks which are expected to maintain sustainableyields above 3.25 percent in the coming year, the industrials,consumer staples and consumer discretionary sectors eachrepresent 17 percent of the basket but remain behind financials,which dominate with over 36 percent.
Among the financials to make it in are UK insurer Amlin, Legal & General and French reinsurer Scor.
While renowned for their often above-average dividendpayouts, only one utility and one telecom stock feature in thebasket, as they are seen as less sustainable in the long-term.
"It's important to avoid the dividend traps ... A yield of 9or 10 percent usually tells you that trouble is coming, that thecompany's cash flow is not stable," Oliver Pfeil, portfoliomanager, global equities, at Deutsche Asset & Wealth Management,which has about 1 trillion euros ($1.35 trillion) in assetsunder management.