/The Risks of Chasing High Dividend Stocks

The Risks of Chasing High Dividend Stocks

The main risks of high dividend stocks are an inability to make dividend payments and interest rate risk. High dividend stocks can be exceptional opportunities for savvy investors who are able to earn juicy yields on their investments while they wait for the price to appreciate. However, it is important to conduct proper due diligence to ensure that dividend payments will be made.

High dividend stocks can be rewarding and lucrative investments if they have committed management teams and strong balance sheets. Sometimes, companies with long-term track records of making payments encounter short-term troubles or poor market conditions that lead to short-term weakness. This decline in stock price has the effect of temporarily elevating the dividends, creating opportunities for proactive investors.

Dividend stocks tend to be affected by interest rates in addition to the performance of the underlying business. When interest rates rise, dividends become less attractive to investors, leading to outflows. Some of the sectors that contain the most high dividend stocks are real estate investment trusts (REITS), utilities, master limited partnerships and consumer staples.

High Dividends Can Be Fool’s Gold

While high dividends are naturally appealing to investors, this should also raise suspicion. In some cases, a high dividend can signal that a company is in distress. Investors who buy solely on the basis of the dividend may experience losses as the dividend is cut and the stock price declines in response.

The market is forward-looking and may begin to discount underlying problems, which temporarily makes the dividend look more attractive. For example, suppose Stock XYZ is trading at $50 and pays an annual dividend of $2.50, giving it a yield of 5%. Some negative external shock leads to a loss in earnings power, and the stock declines 50% to $25. Dividends are not typically cut immediately; therefore, at a superficial glance, an investor may see that the yield on the stock is now 10%.

However, this high yield is a temporary state of affairs as the same catalyst that cratered the stock price would most likely lead to a reduction in the dividend. At other times, the company may elect to keep the dividend and reward loyal shareholders. Thus, investors must look into the financials and operations of the company in question and determine whether the dividend can be maintained. Some factors to investigate are management’s track record in paying and raising dividends, the strength of the balance sheet and free cash flow (FCF).

Interest Rate Risk

Dividend yields are constantly being compared to the risk-free rate of return. Most investors evaluate dividends relative to this measure rather than on an absolute basis. When interest rates rise, it inevitably leads to outflows in high dividend stocks, leading to falling stock prices and a higher dividend yield.

Some of the economic conditions in which interest rate risk is heightened are environments of strong growth with inflationary pressures. If central banks decide that price stability is becoming an issue, they will elect to raise interest rates, which begins an unwind in all yield-generating instruments. High dividend stocks would feel the harshest effects as their spread between yield and the risk-free rate of return would have the sharpest contraction.

Interest Rate Risk in Action

An example of interest rate risk for high dividend stocks is January 2015 through June 2015. This period experienced rising interest rate risk with a healing labor market, an improving economy and comments from Federal Reserve policymakers that interest rate hikes were on the horizon if the economy maintained its trajectory.

Over this time period, persistent weakness existed in sectors with the highest yields. For example, the utilities index fell nearly 20% over this time period, and the Dow Jones Wilshire REIT fund declined nearly 15%. In comparison, the S&P 500 was up around 2% over the same time period.