The low interest rates offered by banks today give investors a tremendous incentive to consider dividend stocks. According to the FDIC, the average national rate on a savings account is 0.06%. In comparison, the average S&P 500 dividend stock yields just under 2%.
However, dividend stocks come with significant risks, especially when yields reach levels significantly higher than the S&P 500 average. Still, by knowing these three potential issues, investors can address potential problems early and avoid many of the pitfalls that affect dividend investors.
1. Dividends, stock values not guaranteed
Investors should remember that dividends are optional. In theory, a company's board can increase, reduce, or eliminate a payout at any time, for any reason.
In reality, dividend cuts and suspensions can lead to a mass sell-off in a stock. This happened to several companies during the recent COVID-19 crisis as companies found themselves with reduced revenue.
Oil services company Schlumberger and gaming giant Las Vegas Sands are examples of companies that reduced or suspended dividends amid falling revenue during the pandemic. Both stocks also remain well below pre-pandemic levels as of the time of this writing.
Understandably, most investors want to avoid these dangers. Some investors mitigate this issue by investing in Dividend Aristocrats, stocks who have increased their payout for at least 25 consecutive years. The long track record of payout hikes reduces the risk a company will put a stock's value at risk with a dividend cut.
However, even Dividend Aristocrats are not foolproof. If a company's balance sheet becomes irreparably compromised, these stocks may have to abandon their status and reduce payouts.
2. Rising payout ratios
Also, less dramatic events than pandemics can endanger a dividend, particularly when yields are high. For this reason, investors need to watch a metric called the dividend payout ratio. The payout ratio is simply the percentage of net income that the company pays out to shareholders in the form of dividends. Schools of thought differ on how to define a "safe" dividend payout ratio. Nonetheless, most analysts consider ratios at or below 50% as sustainable. Unfortunately, higher yields tend to come with higher payout ratios. This is true even with Dividend Aristocrats such as AT&T or ExxonMobil.
Moreover, investors need to measure real estate investment trusts (REITs) by a different financial metric. Investors should evaluate REITs using funds from operations, or FFO income. This is because net income includes depreciation, a non-cash charge that does not hamper a company's ability to pay dividends.
For this reason, payout ratios above 100% are not necessarily a concern with REITs, who must pay out at least 90% of their net income to shareholders. Investors must merely make sure that the dividend remains below FFO income to maintain the sustainability of the payout.
3. Interest rate risk
Additionally, investors also should watch the fixed income market. Bank interest rates have remained low for years. Consequently, many dividend investors forget about interest rate risk, the possibility that a stock's value can fluctuate based on changes in interest rates.
This should deeply concern dividend investors. Should interest rates rise dramatically, fixed income instruments could offer yields that significantly exceed dividend yields. Not only would dividend investors miss out on higher returns, but they could also see stock prices fall as investors switch from dividend stocks to these fixed-income alternatives.
High-yield dividend stocks are not immune. Some older investors may remember that interest rates often approached double-digit percentages during the inflationary period of the late 1970s and early 1980s.
Moreover, interest rates do not have to go into the double-digits to endanger dividend stocks. As mentioned before, these yields come in just below 2% in the S&P 500. Under such conditions, even savings account or bond yields in the 5% range would not spare most of the high-yield dividend stocks.
Investors should also remember that many fixed income instruments such as bonds or certificates of deposits (CDs) have a requirement to both pay interest and protect the amount of principal. CDs also offer FDIC insurance on amounts under $250,000, thus guaranteeing returns.
As mentioned before, dividend investors receive no guarantee on either the stock price or the dividend itself. This fact makes watching the fixed income market all the more critical.