Which 6%+ dividend yield is the better buy: BP plc vs. HSBC Holdings plc

HSBC, Paris

There aren't many 6%+ dividend yields out there these days, but two traditional income investor favourites -- BP (LSE: BP) and HSBC (LSE: HSBA) -- are still rewarding shareholders with hefty annual yields of 6.63% and 6.08%, respectively.

But which is the better option?

Dividend sustainability

Income investors seeking a reliable payment from their holding know that the sustainability of payouts is just as important as how big the quarterly cheque is.

On this front BP isn't looking too healthy. Last year was the second year running that earnings didn't cover the company's dividend payments and analysts are forecasting this will hold true in 2017 as well.

It's easy to understand why when we look at the company's cash flow statement from 2016. Largely thanks to enviable downstream refining and trading assets, operations did kick off $10.6bn in cash flow. But this was entirely swallowed up by $16.7bn in capital investments and the $4.6bn paid out to shareholders through dividends. With gearing at 27% the company has some room to continue tacking on debt to reward shareholders, but this situation can't persist indefinitely.

HSBC's dividend was also uncovered in 2016, but the bank is still in a better position to continue paying out hefty dividends in the future. This was because headline losses were due to non-cash charges -- underlying operations still generated enough cash to cover the $9.1bn in payouts last year.

If HSBC is able to maintain steady dividend payments, even as it grapples with the rock bottom interest rates and falling trading profits that are weighing on all large banks, then it bodes well for the long term sustainability of shareholder returns. HSBC wins this round.

Dividend growth potential

For BP this one is harder to answer. While management can, and is, taking action to improve cash generation by cutting operating costs and selling off assets, it cannot do much to affect the price of oil. And this will be the main driver of whether or not dividend payments can grow in the future.

And the outlook here is murky as ever. OPEC appears to be moving towards extending their supply cut agreement but this has so far had little impact on crude prices, which continue to hover around $52/bbl. This isn't great news as the company is targeting $60/bbl as the point at which it cash from operations will cover capital expenditure and dividend payments.

Analysts aren't forecasting HSBC to raise normal dividends for the next two years but there is good reason to expect a handful of special shareholder returns may be on their way. At the end of 2016 the bank's CET1 ratio, the key metric of balance sheet health for banks, stood at 13.6%.

This is well above many London-listed peers and as the company continues to cut assets and raise cash through disposals it will have even more financial flexibility. The bank has already returned $2.5bn of this to shareholders through share buybacks and with little need to bolster capital reserves investors should ready themselves for more returns in the future.

All in all, to me it looks to me as though HSBC's dividend growth potential and higher margin of safety makes it the clear winner of this contest.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended BP and HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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