High dividend stocks can provide exceptional opportunities for savvy investors. Who wouldn't jump at the chance to earn a juicyyieldon their investment? But investors should be wary of chasing high dividend stocks, as all might not be as it seems. A company's high dividend might be because its stock has suffered a significant drop in share price, suggesting financial trouble that could imperil its ability to make future dividend payments. In addition, investors should be aware of interest rate risk and how an environment of rising rates makes dividend stocks less attractive. We discuss both potential pitfalls in detail below.
Key Takeaways
- A high dividend yield might indicate a business in distress. The yield could be high because the company's shares have fallen in response to financial troubles, and the struggling company hasn't cut its dividend yet.
- Investors should scrutinize a company's ability to pay consistent dividends, which includes examining its free cash flow, historical dividend payout ratio and other metrics of financial health.
- Dividend stocks are vulnerable to rising interest rates. As rates rise, dividends become less attractive compared to the risk-free rate of return offered by government securities.
High Dividends Can Be Fool's Gold
While high dividends have a natural appeal, investors should be careful they are not buying fool's gold. An investor should ask, why is the dividend yield so high? In some cases, a high dividend yield can indicate a company in distress. The yield is high because the company's shares have fallen in response to financial troubles. And the high yield may not last for much longer. A company under financial stress could reduce or scrap its dividend in an effort to conserve cash. This in turn could send the company's share price even lower.
For example, suppose Company XYZ trades at $50 and pays a $2.50 annual dividend for a 5% yield. A negative external shock sends the stock to $25. The company may not cut its dividend immediately. Therefore, at a superficial glance, Company XYZ appears to now be paying a 10% dividend yield.
However, this highyield could be temporary. The same catalysts that cratered the stock price could lead Company XYZ to reduce its dividend. At other times, a company might elect to keep its dividend intact as a reward to loyal shareholders. Thus, investors should look to a company's financial health and operations and determine whether its dividend payments can be maintained.
Key factors to investigate are the company's free cash flow, historical dividend payout ratio, historical dividend schedules, and whether the company has been increasing or decreasing payments. Many of the best dividend payers are blue chip companies with a steady record of producing revenue and income growth over multiple quarters and years. With strong underlying fundamentals comes a reputation for consistent dividend payments. That said, there are always new companies establishing themselves as dividend payers, while others struggle to establish a record of consistency that investors crave. It's important for investors to maintain steadfast due diligence.
Real estate investment trusts (REITs), utilities, master limited partnerships andconsumer staples are among the sectors that pay high dividends.
Interest Rate Risk
High dividend stocks are among a group of assets that are subject to interest rate risk. Generally speaking, high dividend stocks become more attractive as interest rates fall. But when the Federal Reserve tightens monetary policy by raising interest rates, dividends become less attractive to investors, leading to an outflow in equities in general and dividend stocks in particular.
This is because investors compare yields with the risk-free rate of return they can earn by holding a government bond such as a Treasury bond. Let's return to our earlier example of Company XYZ, which pays a dividend yield of 5%. If interest rates rise from 2% to 4%, suddenly that 5% yield becomes less attractive. This is because most investors will prefer the safety of guaranteed 4% return, rather than risk their principal for an extra 1% yield.
As of September 2020, the low interest rate environment favors dividend stocks. The Federal Reserve target for the federal funds rate, which is the overnight bank lending rate against which many other loans are benchmarked, is set at 0% to 0.25%. The Fed lowered the rate by 100 basis points on March 16, 2020, in response to the challenges facing the economy amid the 2020 crisis. Rates haven't been this low since 2008, when the Fed eased monetary policy amid the 2007-2008 Financial Crisis. Rates stayed low through 2015, when the Federal Reserve slowly began raising them in tune with an improving economy.
FAQs
But investors should be wary of chasing high dividend stocks, as all might not be as it seems. A company's high dividend might be because its stock has suffered a significant drop in share price, suggesting financial trouble that could imperil its ability to make future dividend payments.
What are the disadvantages of high dividend stocks? ›
Other drawbacks of dividend investing are potential extra tax burdens, especially for investors who live off the income. 3 Once a company starts paying a dividend, investors become accustomed to it and expect it to grow. If that doesn't happen or it is cut, the share price will likely fall.
Can you make money chasing dividends? ›
In summary, the dividend capture strategy involves buying a stock just before the ex-dividend date to receive the dividend, then selling it after the price recovers to break even. While potentially profitable, this strategy has several risks for small investors.
Is it good to invest in high dividend yield stocks? ›
In addition to providing consistent income, many dividend-paying stocks are in defensive sectors that can weather economic downturns with reduced volatility. Dividend-paying companies also have substantial amounts of cash, and therefore, are usually strong companies with good prospects for long-term performance.
Why is yield chasing bad? ›
We would strongly advise against this approach as it entails a significant amount of both interest rate and credit risk. High quality, Investment Grade securities rated A are currently yielding less than 3% for a 30-year bond. A 1% increase in interest rates will result in losing approximately 5 years of return.
What is the risk of high dividends? ›
If a company's dividend payments are proportionately higher that what it earns, the dividend may be at risk of being cut or eliminated. Payout ratios over 100 per cent are a red flag.
What is too high for a dividend payout? ›
A payout ratio that is between 75% to 95% is considered very high. It implies that the company is bordering towards declaring almost all the money it makes as dividends. This increases the risk of the company cutting its dividends because our formula is forward looking.
Is it good to chase the dividends? ›
But investors should be wary of chasing high dividend stocks, as all might not be as it seems. A company's high dividend might be because its stock has suffered a significant drop in share price, suggesting financial trouble that could imperil its ability to make future dividend payments.
How to make $1,000 in dividends every month? ›
To generate $1,000 per month in dividends, you'll need to build a portfolio of stocks that will produce at least $12,000 in dividends on an annual basis. Using an average dividend yield of 3% per year, you'll need a portfolio of $400,000 to generate that net income ($400,000 X 3% = $12,000).
How to hedge dividend risk? ›
Dividend arbitrage is intended to create a risk-free profit by hedging the downside of a dividend-paying stock while waiting for upcoming dividends to be issued. If the stock drops in price by the time the dividend gets paid—and it typically does—the puts that were purchased provide protection.
Some of the best dividend stocks include Johnson & Johnson (NYSE:JNJ), The Procter & Gamble Company (NYSE:PG), and AbbVie Inc (NYSE:ABBV) with impressive track records of dividend growth and strong balance sheets.
What are the three dividend stocks to buy and hold forever? ›
The S&P 500 Dividend Aristocrats
| Company | Ticker | Sector |
|---|
| Colgate-Palmolive | CL | Consumer Staples |
| Coca-Cola | KO | Consumer Staples |
| Cincinnati Financial | CINF | Financials |
| 3M* | MMM | Industrials |
63 more rowsTop 25 High Dividend Stocks
| Ticker | Name | Dividend Yield |
|---|
| WHR | Whirlpool | 7.83% |
| ENB | Enbridge | 7.48% |
| EPD | Enterprise Products Partners | 7.34% |
| VZ | Verizon | 6.62% |
6 more rowsMay 10, 2024
“One mistake to avoid,” Cabacungan says, “is to buy a company's stock simply because it issues a high dividend.” If the company has leveraged excessive debt to fund the dividend, it could come at the expense of future profitability and hurt growth prospects.
How risky is high-yield? ›
While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.
What is dividend risk? ›
What positions are subject to dividend risk? If your portfolio contains any short call options, then there is a chance that you may be forced to sell 100 shares (per contract) of the underlying and pay the dividend on the payable date. As a result, your account will be short the stock and owe the upcoming dividend.
What are the negative effects of dividends? ›
After a stock goes ex-dividend, the share price typically drops by the amount of the dividend paid to reflect the fact that new shareholders are not entitled to that payment. Dividends paid out as stock instead of cash can dilute earnings, which can also have a negative impact on share prices in the short term.
What are the disadvantages of stock dividends to a company? ›
Disadvantages of a Stock Dividend
The market may perceive a stock dividend as a shortage of cash, signaling financial problems. Market participants may believe the company is financially distressed, as they do not know the actual reason for management issuing a stock dividend.
Why buy stocks with no dividend? ›
In fact, there can be significant positives to investing in stocks without dividends. Companies that don't pay dividends on stocks are typically reinvesting the money that might otherwise go to dividend payments into the expansion and overall growth of the company.
How much dividend is considered high? ›
1 Therefore, any company that had a trailing 12-month dividend yield or forward dividend yield greater than 4.67% was considered a high-yielding stock. However, prior to investing in stocks that offer high dividend yields, investors should analyze whether the dividends are sustainable for a long period.
