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Are Westpac shares a dividend trap?

The Westpac Banking Corp (ASX: WBC) share price has recovered slightly since hitting a 7- year low in December of last year and is currently swapping hands for around $26.90 at the time of writing.

That’s right, investors who bought Westpac shares in the last 7 years are still most likely underwater, if you don’t include dividends paid. But for a blue-chip dividend payer like Westpac, its all about the dividend for most investors. On current prices, Westpac is yielding a 7% dividend (and if you include franking credits, this becomes a 10% yield). This is one of the highest blue-chip yields on the ASX and is second only to National Australia Bank Ltd (ASX: NAB) amongst the ‘Big Four’ banks.

This is looking very attractive for income investors, especially when you compare it to traditional income investments, like say a term deposit at Westpac or even a government bond. But is this huge yield sustainable, or are Westpac shares a dividend trap to be avoided?

When does a dividend trap happen?

A dividend trap occurs when an investor buys a share for its dividend/income, only to see the payout per share get cut (and likely the share price with it) – resulting in loss of capital and future income.

Westpac’s current payout is 94 cents per share, paid twice a year, which has remained unchanged since 2015. This represents a payout ratio of 80% of profits during the 2018 financial year. This ratio is quite high (Westpac is only keeping 20% of profits for internal reinvestment) but is slightly better than NAB at 85%. For Westpac to be a dividend trap, its earnings would have to take a bit hit. The bank’s payout ratio means that it has a small cushion to absorb a minor hit, but not much more in my opinion.

Are Westpac shares a dividend trap?

Of the just over $8 billion of earnings that Westpac generated in the 2018 financial year, $3.14 billion came from retail banking (mostly credit cards, loans and mortgages), $2.16 billion came from business banking and $1.1 billion from institutional banking. The remaining $1.6 billion is made up of Westpac’s BT financial planning business as well as the bank’s New Zealand branches.

Westpac is heavily exposed to the retail banking sector rather than business banking, which contrasts to NAB, which is the opposite. This means that if there are any adverse developments in the Australian housing market, Westpac’s earnings will suffer and would be the most likely cause of a cut in the dividend.

Foolish Takeaway

While Westpac has a high payout ratio, I believe that the dividend is relatively safe, bar a catastrophic fall in house prices or a similar event. Whilst I wouldn’t count on any big rises in the dividend in the near future, looking at the share price over last 7 years, it might be a good time to buy Westpac if you’re an income investor.

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Motley Fool contributor Sebastian Bowen owns shares of National Australia Bank Limited. The Motley Fool Australia owns shares of National Australia Bank Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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