High dividend stocks can provide exceptional opportunities for savvy investors. Who wouldn't jump at the chance to earn a juicy yield on 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 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 high yield 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 and consumer 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 COVID-19 pandemic. 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.