Investors love dividend stocks, and many people see them as being among the lowest-risk investments in the stock market. Yet even with their reputation for safety, dividend stocks can be dangerous -- and smart investors prepare for those risks by recognizing the damage they can do to their portfolio if they're not careful.
To help you better understand exactly what pitfalls to watch out for, we asked three Motley Fool contributors to talk about what they see as the biggest risks of dividend stocks. Read on to see what they have to say and whether your portfolio might need some adjustments.
One rarely recognized risk of dividend stocks is what happens when a payout is cut.
Besides losing a steady payment, dividend investors flee from stocks that reduce or eliminate their payout. In the rush to get out, investors will likely sell for a low price. The funny thing is that a dividend cut is frequently good for the company, as it allows management to pay off debt or reinvest in the business, rather than distributing the cash to shareholders.
One great example is the rural telecom industry. A few years ago, many of the companies in the industry had high debt loads and were paying out unsustainably high dividends. Both Frontier Communications (NASDAQ:FTR) and CenturyLink (NYSE:LUMN) cut their dividends to pay off debt and reinvest in operations.
In February 2012, Frontier Communications slashed its dividend in order to to pay down debt while continuing to reinvest in its high-speed Internet investments.
In February 2013, CenturyLink reduced its dividend because it was paying out more in cash than it was bringing in. After a 25% dividend cut, the stock fell about as much.
In these cases, it was obvious that a dividend cut was coming, as the companies were paying out more in cash flow than they were collecting. Investors were hoping they could collect the dividends as long as possible and then bail at the same price at which they bought in -- or better. In most cases, though, the investors sold off with all the other dividend investors and got crushed. Don't let this happen to you.
In the financial sector, real estate investment trusts and business development companies are known for their outstanding dividend yields. These businesses are required by law to pay out 90% or more of their income as a dividend, which is good for income seekers. However, this makes shareholders in these companies even more vulnerable to the risks Dan Dzombak outlines above.
Consider that these businesses pay out nearly all of their income because they have to -- not because they want to or because they see it as a sustainable practice.
One of the best in the BDC industry, Ares Capital (NASDAQ:ARCC), had to cut its dividend by 16% during the financial crisis. Rival Apollo Investment (NASDAQ:AINV) halved its dividend, only to make further cuts later. It now pays out 60% less than it did before the financial crisis, and its share price has been more or less stagnant for several years.
Just remember that when a business pays out all of its income as a dividend, any drop in income will ultimately result in a drop in the payout. Even if they seem stable in a calm market, high dividend payouts are highly vulnerable in a downturn.
Most investors think the main risk of dividend stocks is that their quarterly payouts may suffer in hard times, leading to a loss of income when they might need it most. Yet many dividend-paying companies can cost shareholders dearly without making a single change to their quarterly payouts, as income-intensive investments are often sensitive to interest rates.
Over time, many low-growth dividend stocks, such as utilities and telecoms, rise and fall with the general level of interest rates. The reason for this is fairly straightforward: Many investors see conservative dividend stocks as a substitute for fixed-income securities like bonds. When prevailing interest rates fall, a dividend stock with a stable yield looks more attractive, and so its share price will go up to reflect higher demand. When rates rise, though, bonds and other fixed-income investments become more attractive to income investors, and dividend stocks' prices can fall as investors seek a higher effective yield on their shares.
Dividend cuts are a real risk, but don't neglect the influence of interest rates. With many expecting rate hikes in the near future, headwinds could be ahead for dividend stocks.