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
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.
What are the downsides 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.
Does chasing dividends work? ›
A dividend capture strategy can pay off when stock markets are rising. Of course, any strategy that leads you to buy can pay off when stock markets are rising. However, you have to pay a brokerage commission to buy the shares and a commission to sell. The commissions can eat up much of the dividend income.
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.
Is 5% dividend yield possible? ›
Mature, blue-chip stocks like BHP Group Ltd (ASX: BHP) consistently pay a dividend yield of about 5% or 6% (and can sometimes go as high as 10%-plus, depending on commodity prices). That's quite a good annual return.
Why shouldn't you invest in dividend stocks? ›
“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.
What is too high for a dividend payout? ›
A payout ratio over 100 may indicate that the dividend is in jeopardy, because no company can continue pay out more than it earns indefinitely. A very high payout ratio can be a sign to investigate further, but it's not necessarily a signal to run screaming.
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 5k a month in dividends? ›
To generate $5,000 per month in dividends, you would need a portfolio value of approximately $1 million invested in stocks with an average dividend yield of 5%. For example, Johnson & Johnson stock currently yields 2.7% annually. $1 million invested would generate about $27,000 per year or $2,250 per month.
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? ›
Vanguard High Dividend Yield Index ETF
| Company Name | Symbol | Percentage of Assets |
|---|
| JPMorgan Chase | JPM | 3.4% |
| Broadcom | AVGO | 3.4% |
| ExxonMobil | XOM | 2.8% |
| Home Depot | HD | 2.3% |
1 more row3 days ago
Some of the advantages of dividend stocks are that they tend to outperform growth stocks, offer consistent cash flow at regular intervals, and because stocks that offer dividends typically indicate that a company is financially healthy enough to pay shareholders cash, the investment can be less risky.
What is the 4% dividend rule? ›
The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after. The rule seeks to establish a steady and safe income stream that will meet a retiree's current and future financial needs.
What is the safest dividend stock? ›
Top 25 High Dividend Stocks
| Ticker | Name | Dividend Safety |
|---|
| ENB | Enbridge | Safe |
| EPD | Enterprise Products Partners | Safe |
| VZ | Verizon | Safe |
| T | AT&T | Borderline Safe |
6 more rowsMay 10, 2024
For example, if a company issues a stock dividend of 5%, it will pay 0.05 shares for every share owned by a shareholder. The owner of 100 shares would get five additional shares.
What are the negative effects of dividends? ›
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.
Is high dividend payout good? ›
In most cases, firms with a high average dividend payout ratio are preferable for investors because they are likely to provide a steady stream of income. Furthermore, investors are likely to look at the trend in a company's dividend payout ratio before deciding whether to invest.
What are the cons of high dividend ETF? ›
Cons. No guarantee of future dividends. Stock price declines may offset yield. Dividends are taxed in the year they are distributed to shareholders.
Why do high dividend stocks go down? ›
A stock's yield may be high because business weakness is weighing down the company's share price. In that case, the company's challenges may even cause it to lower or stop its dividend payments. And before that happens, investors are likely to sell off the stock.
