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
The risks associated with dividend stocks
How risky are high 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.
Should you invest in high dividend stocks? ›
Companies that pay dividends tend to be well-established, so dividend stocks may also add some stability to your portfolio. That's one reason they're included on our list of low-risk investments.
Is there a downside to dividend stocks? ›
Dividend-paying stocks have the potential for income through dividends and capital appreciation, but they come with higher volatility and market risk. The choice between the two depends on your risk tolerance, investment goals, and time horizon.
What are the disadvantages of a high dividend yield? ›
While high dividend yields are attractive, it's possible they may be at the expense of the potential growth of the company. It can be assumed that every dollar a company is paying in dividends to its shareholders is a dollar that the company is not reinvesting to grow and generate more capital gains.
Can you become a millionaire from dividend stocks? ›
So, Can You Get Rich Off Of Dividends? Dividend investing can indeed be a path to building wealth over time. By harnessing the power of compound interest and carefully selecting dividend-paying stocks, investors can create a growing stream of passive dividend income.
How much dividend is considered high? ›
As of April 26, 2024, the U.S. 10-year Treasury yield was 4.67%. 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.
What are the top 5 dividend stocks to buy? ›
15 Best Dividend Stocks to Buy for 2024
| Stock | Dividend yield |
|---|
| American Tower Corp. (AMT) | 3.4% |
| Pfizer Inc. (PFE) | 6.1% |
| Verizon Communications Inc. (VZ) | 6.6% |
| Southern Co. (SO) | 3.7% |
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One little-known, small-cap, ultra-high-yield dividend stock -- currently sporting an 11% yield -- which doles out its payout on a monthly basis, might the safest double-digit-yielding stock on the planet. Investors, say hello to business development company (BDC) PennantPark Floating Rate Capital (NYSE: PFLT).
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.
But there is one big problem with funds that distribute dividends. What a dividend investor wants is a dividend that grows over time, and that's not usually the case with funds. They tend to adjust the dividend according to the evolution of net asset value-- the development of the market.
Do stocks lose value after dividend? ›
The value of a share of stock goes down by about the dividend amount when the stock goes ex-dividend. Investors who own mutual funds, stocks, and other securities should find out the ex-dividend date for those investments and evaluate how the distribution will affect their tax bill.
Should I put all my money in dividend stocks? ›
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price. This total return can add up over time.
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.
What is a major disadvantage of receiving stock dividends? ›
A few dangers to be aware of: In general, dividend-paying companies see less price appreciation than growth stocks. Share prices can drop whether the stock pays dividends or not. Companies can slash or eliminate their dividend payments at any time for any reason.
What happens if you take too much dividend? ›
If a company pays out more dividends than it can afford, the excess amount must be returned to the company or be added to the director's loan account as a debt from the shareholder to the company. Having an overdrawn directors loan account can result in both income tax and corporation tax consequences.
What is too high for a dividend payout? ›
A low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations. A payout ratio over 100% indicates that the company is paying out more in dividends than its earnings can support and this could be an unsustainable practice.
What happens if you pay too much dividends? ›
If a company pays out more dividends than it can afford, the excess amount must be returned to the company or be added to the director's loan account as a debt from the shareholder to the company. Having an overdrawn directors loan account can result in both income tax and corporation tax consequences.
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.
