Dividend investors are always looking for income, and for some investors, the more income they get, the better off they are. Yet with high-yield dividend stocks, you always have to be on the lookout for reasons why their payouts might suddenly decline. The reason: Dividend cuts hurt shareholders twice, once when they get less in dividend income, and a second time because of the typical decline in the share price that occurs after a reduced payout.
It's important to keep an eye on all high-yield dividends to see whether they're sustainable. Below, you'll find three investments whose dividends warrant extra scrutiny in 2015 from those who fear a potential dividend cut.
The REIT stuff for dividends?
Real estate investment trusts that invest in mortgage-backed securities have been extremely popular lately, because conditions have been ripe for high dividends for years. Annaly Capital (NYSE:NLY) is just one of many mortgage REITs sporting double-digit yields right now. Yet even though Annaly shareholders have enjoyed yields of 10% and above for years, their total returns haven't been nearly as impressive because of the consistent downward drift in dividend payouts and the REIT's share price. Over the past four years, a decline of nearly 40% in Annaly has all but wiped out all the dividends the REIT has paid in that time frame. Over that period, Annaly's dividend has been cut in half.
Looking forward, Annaly faces a dual challenge. On one hand, long-term interest rates fell sharply in 2014, and that reduced the spread Annaly earns between its short-term borrowing costs and the returns on its long-term fixed-income investments. Yet Annaly also has to deal with the likelihood that the Federal Reserve will start boosting short-term interest rates in 2015, putting further pressure on its interest margins and potentially forcing further reductions in its payout. Those conditions could continue to hurt Annaly's total return and make its current high yield deceptively attractive.
Running out of energy
The oil and gas boom has brought big success to the energy industry, and many companies have enjoyed huge bumps in revenue and earnings in recent years as the price of oil remained near or above $100 per barrel for a long time. In particular, high oil prices made offshore drilling much more economically viable, and Ensco (NYSE:ESV) was one of the key beneficiaries of the offshore-drilling trend, leasing out its equipment for hundreds of thousands of dollars per day and financing a dividend that currently implies a yield of more than 10%.
The plunge in oil prices has already led to dividend casualties elsewhere in the space, though, as Seadrill (NYSE:SDRL) announced late last year, it would suspend its once-lucrative payout entirely in order to focus on reducing its debt and saving capital for what it calls "value-creating opportunities." Day rates on both deepwater floating rigs and standard jackups have fallen precipitously, and most in the industry expect them to decline further as offshore activity slows because of falling prices. Given those conditions, it's likely Ensco will have to cut its dividend at some point in 2015 unless oil rebounds quickly.
Will BDC dividends go MIA?
Another popular high-yield area is the business development company sector, which, like REITs, have taken advantage of low financing costs to boost their income and pay out more in dividends. Fifth Street Finance (NASDAQ:FSC) is one example of a BDC with a double-digit dividend yield, with its emphasis on making loans to middle-market companies having been extremely profitable in a low-rate environment.
Recently, though, some gaps in the armor of BDCs have surfaced, with Prospect Capital (NASDAQ:PSEC) having slashed its payout for the months of February through April by 25%. With Fifth Street's earnings having failed to keep up with its dividend payout, many investors are increasingly concerned that the BDC will be the next to make a cut. Moreover, with longer-term worries stemming from potential interest rate increases from the Fed, BDCs across the spectrum could face a tougher environment ahead.
High dividend yields always look promising, but it doesn't pay to be greedy. Before you buy a high-yield dividend stock, make sure you know all the risks and are prepared to accept them in your portfolio.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.