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 is the downside to 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.
Is it good to chase the dividends? ›
Don't chase high dividend yields
If a high or rising yield is due to a shrinking share price, that's a bad sign and could indicate that a dividend cut is on the horizon. If a rising dividend yield is due to rising profits, on the other hand, that's a much more auspicious sign.
Should you invest in high yield 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.
What are the disadvantages of a high dividend yield? ›
Sometimes high yield can be misleading since it may indicate a falling stock price instead of an increase in dividend payment. This indicates that the company may have financial difficulties, or the financial market may perceive the stock as less valuable. The yield is only relevant for those stocks that pay dividends.
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 a high dividend bad? ›
Company Fundamentals. High dividend yields can be attractive, but sometimes they can be a sign that a company is facing problems. A higher yield can occur when the stock price falls due to a decrease in the company's earnings or because of declining investor sentiment.
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.
Are monthly dividend stocks safe? ›
Monthly dividends can be reliable source of income and act as a safeguard against inflation. Stock market investors appreciate dividends. Dividends provide cash flow and enhance total returns. They allow investors to participate directly in the revenue and earnings of the companies in their portfolios.
What are the pros and cons of dividend stocks? ›
The Pros & Cons Of Dividend Stock Investing
- Pro #1: Insulation From The Stock Market. ...
- Pro #2: Varied Fluctuation. ...
- Pro #3: Dividends Can Provide A Reliable Income Stream. ...
- Con #1: Less Potential For Massive Gains. ...
- Con #2: Disconnect Between Dividends & Business Growth. ...
- Con #3: High Yield Dividend Traps. ...
- Further Reading.
The performance of dividend stocks has remained strong in previous inflationary periods. In Our article titled 25 Things Every Dividend Investor Should Know, we cited data from Hartford Funds, which analyzed the returns of dividend stocks in periods of high inflation.
What is the best dividend stock to buy right now? ›
10 Best Dividend Stocks to Buy
- Verizon Communications VZ.
- Johnson & Johnson JNJ.
- Philip Morris International PM.
- Altria Group MO.
- Comcast CMCSA.
- Medtronic MDT.
- Pioneer Natural Resources PXD.
- Duke Energy DUK.
If you are looking to create wealth and have a longer time horizon, staying invested in growth will enable you to enjoy longer returns. But if you are looking for a more immediate return and steady cash flow, dividend investing could be the best choice for you.
What is the highest paying dividend stock that pays monthly? ›
Top 10 Highest-Yielding Monthly Dividend Stocks in 2022
- ARMOUR Residential REIT – 20.7%
- Orchid Island Capital – 17.8%
- AGNC Investment – 14.8%
- Oxford Square Capital – 13.7%
- Ellington Residential Mortgage REIT – 13.2%
- SLR Investment – 11.5%
- PennantPark Floating Rate Capital – 10%
- Main Street Capital – 7%
Dividend kings list 2024
| Name | Ticker | Streak (years) |
|---|
| Farmers & Merchants Bancorp | FMCB | 58 |
| Federal Realty Investment Trust. | FRT | 56 |
| Fortis Inc. | FTS | 50 |
| Genuine Parts Co. | GPC | 67 |
40 more rowsA high dividend yield can be appealing since you're getting more income per dollar invested, but a high yield isn't always a positive thing. It could mean that the company's stock price has been falling or dividend payments have been increasing at a higher rate than the company's earnings.
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 is a high dividend payout ratio bad? ›
The dividend payout ratio is a vital metric for dividend investors. It shows how much of a company's income it pays out to investors. The higher that number, the less cash a company retains to expand its business and its dividend.
Is 10% dividend yield high? ›
These businesses maintain prudent dividend policies, strong balance sheets, and operations that generate predictable cash flow. The top 25 high dividend stocks analyzed below possess these traits and have: A dividend yield above 4% (some as high as 10%) A Borderline Safe, Safe, or Very Safe Dividend Safety Score™
