How Dividend Stocks Could Destroy You

Dividend stocks are all the rage among investors. Yet while their unique combination of potential future growth and attractive current income justifies investors' interest in them, they're not bulletproof -- and using risky investing strategies to try to take advantage of high dividend yields can come back to bite you.

The carry trade at work
Right now, dividend-seeking investors find themselves in a situation many have never faced before. Interest rates on bonds and other fixed-income investments are at historic lows. Many dividend-paying stocks, on the other hand, are mired in the stock market's malaise. The combination of depressed stock values and the rising dividends that many companies have paid out in recent months has led to impressively high yields for those stocks -- yields that greatly exceed what you can earn from other investments.

In fact, the disparity is so wide that I've started to see a new strategy thrown around. It's a variation on what's known as a carry trade, where you borrow money at low rates in order to buy investments that are paying a higher rate. In a nutshell, here's how it works: Go to your broker and take out a margin loan. Use the money to invest in high-yield dividend stocks. With some brokers offering margin loan rates below 2%, you can pocket some nice profits just based on the dividend income you receive every quarter. And if some of those great values among dividend payers see their share prices recover to more reasonable levels, then the capital gains you could earn are just icing on the cake.

Risk and reward
This certainly isn't the first time that people have suggested that carry-trade strategies can enhance your profits. For decades, investors have used currency-based carry trades, borrowing in low-interest currencies like the Japanese yen and buying assets in countries paying higher rates. Similarly, borrowing at low short-term rates and then lending that cash out at higher long-term rates is the fundamental business model that most banks have employed to produce big returns lately, thanks to big spreads between short and long rates.

Yet whatever form it takes, carry trades always have risks. With currencies, adverse changes in exchange rates can turn profits into losses. With interest rate spreads, changing rates can increase your borrowing cost above what you earn on the money you lend out.

The dividend stock carry trade is particularly risky because there are several things that can go wrong:

  • Margin borrowing rates can rise suddenly, increasing your borrowing cost and making the position unprofitable.
  • Dividend stocks can cut their payouts, leaving you without the income you expected to pay the interest on your margin loan.
  • Worst of all, stock prices can fall, potentially creating a margin call and forcing you to liquidate at exactly the worst time.

We've seen all three of those things happen in the past. After the tech bubble burst, the Federal Reserve lowered interest rates dramatically. Yet in 2004 and 2005 after the economy rebounded, the Fed quickly raised rates, putting short-term borrowers in a bind.

Investors know all too well that dividends aren't always safe. For instance, when Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Fifth Third Bancorp (Nasdaq: FITB  ) first got blindsided by losses, they each slashed their formerly healthy dividends -- only to end up cutting them further later on in the credit crisis.

Even when dividends are stable or grow, bad markets can hurt dividend stocks in the short run. Consider how much these high-yielding stocks lost during 2008:

Company

Current Yield

Stock Loss During 2008

Frontier Communications (NYSE: FTR  )

9.8%

(23.5%)

Altria Group (NYSE: MO  )

6.6%

(30.4%)

Exelon (NYSE: EXC  )

5%

(29.4%)

Duke Energy (NYSE: DUK  )

5.7%

(21.1%)

Sources: Yahoo! Finance, Morningstar.

Notice that those losses are actually less severe than the overall market's drop that year. Yet even with the greater stability that dividend stocks provide, they can still suffer big losses during bear markets, erasing several years' worth of dividend payments. And when you're leveraged with a margin loan, losses of that magnitude can put you in a position where you have no choice but to liquidate your holdings and take a permanent loss.

Stay safe
Dividend stocks are giving investors a big opportunity right now, but it's not worth taking huge risks to profit from them. Wall Street had to learn its lesson the hard way about how leverage can destroy your assets. Don't let yourself follow in its footsteps.

Is now really the time to take more risk? Jordan DiPietro sees investors on the verge of yet another disaster.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger knows that low rates are hard to resist, but margin isn't worth it. He doesn't own the stocks mentioned in this article. Exelon is a Motley Fool Inside Value pick. Duke Energy is a Motley Fool Income Investor recommendation. The Fool owns shares of Altria Group and Exelon. Try any of our Foolish newsletters today, free for 30 days. You'll never get a margin call from the Fool's disclosure policy.


Read/Post Comments (12) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 10, 2010, at 2:42 PM, cedricjrwork wrote:

    Take it from an ex-WorldCom margin trader: don't bet more than you can emotionally stand to lose. Right, Mr. Ebbers?

  • Report this Comment On September 10, 2010, at 4:48 PM, mnights wrote:

    So if i plan on investing over a 20 year term, don't use margins, and invest only in US based companies that pay dividends... will my portfolio not be destroyed by the dividend death star?

  • Report this Comment On September 10, 2010, at 5:37 PM, WACowboy wrote:

    What a bone head article. Why not just study several high-dividend issues, such as an MLP's (master limited partnership), check out their history of dividends paid (if your really worried get the longest period of continuous dividend payments you can find) and just buy the issue. Stand with that issue through thick and thin. Don't sell the first time is dips below your purchase price unless the management is being sent to jail for imbesselment. You'll do fine. Just wisely invest your dividends either through a DRIP program or find another, equally attractive issue and buy that.

    It is really very simple.

  • Report this Comment On September 10, 2010, at 5:46 PM, DivingDan wrote:

    The title of the article is incomplete. Should read "How borrowing on margin to buy dividend stocks could destroy you." Personally, borrowing to invest is a dumb move for the reasons stated. That's why we don't do it! DUH

  • Report this Comment On September 11, 2010, at 11:34 AM, jackthemack2 wrote:

    STOXX Americas Dividend Select 40 highest dividend yielding stocks:

    http://www.stoxxdividend.co.nr

  • Report this Comment On September 11, 2010, at 2:15 PM, ChrisFs wrote:

    The title is misleading. It should be "How borrowing money to buy stocks could destroy you", Dividend stocks have nothing to do with this. It just makes for a title that more people will click on.

  • Report this Comment On September 13, 2010, at 3:52 PM, Borbality wrote:

    Hey at least it's not saying to short everything.

  • Report this Comment On September 16, 2010, at 9:29 AM, twocoins wrote:

    What on earth is happening to the Motley Fool ?

    I am really disappointed that they have strayed so very far from what they were a few years ago.

    Perhaps we were duped to join them and now we are getting CRAP from them.

    I fear we can not trust them anymore ???????

  • Report this Comment On September 16, 2010, at 5:36 PM, RoadRunner91910 wrote:

    While growing up, one of the more irritating habits my mother had was to repeatedly use the expression, "Well they say ..." This was usually followed by some dubious statement e.g. "They did a study and they say the best investment over time is the 5% Passbook saving's account."

    As I got older, I would call her on this by responding, "Who is 'they' because if I am looking for

    marital advice I sure as hell don't want to be consulting a supposedly celibate priest!"

    My point is simply this. The name of the author of the article posted above is Dan Caplinger. Check him out. Read his bio. Read some other of the other articles he has wrote, and sold, to this site. What is his investing track record? Does he have a particular bias?

    The Motley Fool really is our - the readers and frequent comment providers - site. If the information posted here is not beneficial, it is our fault.

  • Report this Comment On September 17, 2010, at 6:44 PM, phoebe44 wrote:

    Thank you RoadRunner91910

  • Report this Comment On September 20, 2010, at 5:41 AM, TimoDOZ wrote:

    Ditto Two coins! This is an advertising agency not a financial advisory service. They are screaming Danger Will Robinson but the price on DD just keeps going higher and the yield lower. Some thing about a business plan that is working. A lot of that international exposure too. Besides carry trade there is the tripling of US corn exports in 4 years and the 6% increase in Soybeans being exported to China just

    this year. DD with it's drought resistant seed strains selling well domestically and gaining in demand internationally. Some ones's got to "carry" the "stuff" to China. NMM maybe? Aren't most companies paying dividends out of profits? What was wrong with owning MMR-M or HL-C at $75? The risk of course of the distributions not being made. Profits returned and so did the dividends and the stocks went back to $100 par. If you liked the MMR-M chart you might like the GDPAN chart as well. There is only risk and then at times reward.

  • Report this Comment On September 24, 2010, at 11:39 AM, uptickusa wrote:

    FTR's dividend is highest in S and P-There for

    all the talking heads are bashing it Well yhey are foolish because this wieless communication company is a cash cow which can support any dividend they put out.The last cut was explained as a means of reducing debt and even wiyh the 25 cent haircut still the highest paying yield.Don't liste to kramer who uses stocks as examples to teach making points in his sratagies

    UPTICKUSA

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