Sound Advice: May 24, 2023

The Risk of High Dividend Yields

Over the last decade and a half, it’s been a challenge finding generous current returns on investments.  That’s especially true for the fixed-income market (primarily bonds), which most of the time has been a relatively safe haven for those seeking assured returns.  The reality is that recent years have not been a mirror for “most of the time.”

The problem is interest rates.  As interest rates rise, the values of fixed-income investments fall.  Why?  Because interest rates tend to move in relation to rates set by the Federal Reserve Board.  The Fed’s efforts are aimed at stimulating or cooling the economy.

For an extended period, interest rates have been bobbing along the lowest end of the yield spectrum.  At the start, the central bank opted for well above average stimulation to counter the impact of the 2008-9 financial crisis.  For bond investors, that continued the pattern that provided significant capital appreciation as well as interest on their holdings.

But as inflation ballooned over the latest three years, the Fed did a marked about-face, boosting interest rates at an unprecedented pace to bring things under control.  That was bad news for bonds, which lost considerable principal value.

That may change as the economy and inflation weaken.  In the interim, those seeking substantial yields have turned their attention to high dividend yielding stocks, often via exchange-traded funds.  On the surface, that seems to be a comfortable approach.  But there are risks.

Consistent and reasonably assured high dividend yields are often available from mature, industry-leading companies that are largely insulated from major economic shifts.  But there are others where the surrounding moat is shallow. 

One group consists of companies in cyclical industries, which follow boom-and-bust cycles.  Another group would be companies that have not kept up with changing technology, placing them in the awkward position of having increasing difficulty maintaining dividend payouts to shareholders. 

These companies are identified by viewing what’s known as the dividend payout ratio.  That’s dividends paid as a percentage of the company’s net income.  It’s a check on whether there’s enough money to make regular quarterly payments.

In rare cases, there may be lean periods when more is going out than coming in, but typically it’s a process that just gets worse.  When this happens, dividend rates get cut and then they are eliminated.

It doesn’t stop there.  When dividends are gone, asset managers holding dividend stocks have to sell their holdings, which may lead to a further loss in value.

 

N. Russell Wayne, CFP^Ò

Any questions?  Please contact me at nrwayne@soundasset.com