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 dividend yield, 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 equity outflows in general and particularly selling in dividend stocks. Some of the sectors that contain the most high dividend stocks are real estate investment trusts (REITS), utilities, master limited partnerships and consumer staples. Large cap indexes like the Dow Jones and S&P 100 are also full of dividend stocks.

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 key factors to investigate are the company’s free cash flow, historical payout ratio, historical dividend schedules, increases and decreases, management’s strategy and the strength of the company’s overall financial position. Many of the best dividend paying companies are often blue chips in their industry with a steady record of producing revenue and income growth over multiple quarters and years. This reputation and credibility often lends itself to the strong underlying fundamentals that are associated with many dividend paying companies. That said there can also always be new dividend payers breaking into the mix and companies who are beginning to struggle with their dividend payouts. As such, it is important to maintain steadfast due diligence.

Dividend yields are constantly being compared to the risk-free rate of return which generally increases in environments where the Fed is tightening monetary policy. Many investors evaluate dividends and dividend investments relative to this measure rather than on a purely absolute basis. When interest rates rise, it inevitably leads to outflows in high dividend stocks, also causing stock prices to decrease and a higher dividend yield. Dramatic changes in interest rates can be a catalyst for many changes in the market and potentially the onset of a bear market so it is an important factor to follow for a multitude of investing decisions.

Since 2015, the Fed has been steadily raising rates. The tightening in policy is affecting the stock market’s nearly nine years of bullish returns which has also been aligned with a healing labor market, an improving economy and increasing inflation. Many short-term periods of equity selloffs have begun to arise in the market and as such, 2018 and 2019 may be an optimal time to closely consider some of the best high dividend stocks while also reallocating some investments to take advantage of a higher risk-free rate in liquid cash savings and short-term bonds.