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
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 |
9.8% |
(23.5%) |
|
Altria Group |
6.6% |
(30.4%) |
|
Exelon |
5% |
(29.4%) |
|
Duke Energy |
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.
