As a dividend investor, you want your stocks to produce as much income as possible, while still being safe and responsible investments. So, we could say that a double-digit dividend yield that was actually safe could be considered the "Holy Grail" of dividend stocks.
But is there such a thing as a safe dividend stock that yields 10% (or more) per year? To answer this question, we need to take a look at what makes a dividend safe, and whether any of the typically high-paying stocks qualify.
What makes a dividend safe?
First, the stock's payout ratio needs to be reasonable. A payout ratio is the ratio of the dividends a company pays out to the earnings it brings in. For example, if a company earns $1.00 per share and pays $0.40 in annual dividends, its payout ratio is 40%. Generally, for a dividend to be healthy, a payout ratio should be 50% or less.
One exception to this rule involves companies that are required to distribute at least 90% of their taxable income to shareholders, such as REITs. Naturally, payout ratios approaching 100% are to be expected.
Also, in order for a dividend to be safe, the company's income must be relatively stable and predictable. If a company makes $5.00 per share one year and $2.00 the next year, it may be hard to maintain its dividend, as investors in many oil stocks (such as Linn Energy and Seadrill) recently learned the hard way.
The usual suspects: mortgage REITs
Perhaps the most well-known high-paying stocks are the mortgage REITs, or mREITs. Most of these companies have healthy payout ratios, but the problem is that their earnings can be downright erratic under the wrong conditions.
Mortgage REITs make their money by borrowing at low short-term interest rates and buying mortgage-backed securities, which pay higher long-term interest rates. The spread between the two rates becomes the mREIT's profit.
However, the spread between the rates is usually around 2%. In order to produce the double-digit yields they want, mREITs use high amounts of leverage. For instance, two very popular mREITs, Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) have leverage rates of 5-to-one and 6.9-to-one, respectively.
So, if interest rates were to suddenly spike, as they did in the middle of 2013, the spread between the short-term rates the companies pay and the mortgage income can narrow. And because of the high leverage ratios, the profits can sharply decline or even disappear altogether. Just look at the spike in rates, and how it affected the dividends of the two mREITs mentioned.
The usual suspects: business development companies (BDCs)
Business development companies, such as Prospect Capital Corp (NASDAQ:PSEC), have a fairly straightforward business model. Loan money to stable companies that can't get bank financing, and charge relatively high interest rates. And to boost profits, these companies tend to use some leverage, but not to the extent of mREITs.
However, there are a few potential issues here. First is the risk of one of the company's investments defaulting, which isn't very common, but it does happen. Many BDCs, including Prospect, have over 100 investments, but are very heavily weighted toward certain ones.
Also, there is a risk of dilution. Prospect recently sold shares below net asset value (NAV) in a move that turned many investors off. This effectively dilutes shareholders' ownership, and serves the purpose of generating higher fee income for management.
Finally, BDCs aren't immune to dividend cuts. In fact, Prospect was recently forced to reduce its dividend for the first time in years.
"Deceptive" high yields: beaten down stocks
Finally, another type of high-yield stock to watch for are stocks that have high dividends because the share price has fallen dramatically. One example that comes to mind is Transocean (NYSE:RIG).
Because of the drop in oil prices, Transocean is seeing less business and analysts expect many of the company's drilling rigs to be idled if prices don't recover soon. As a result, the company's stock price has fallen by about 65% since last summer and the $3.00 annual dividend translates into an astronomical 19% yield.
This is not sustainable, especially if oil stays cheap. Transocean is expected to earn just $2.09 per share in 2015, which would result in a payout ratio of nearly 150%. And 2016 is supposed to be even worse, as much of the company's backlog of business is set to run out.
So, are any of them "safe"?
In general, the higher the dividend, the more risk you're taking on. There are exceptions, such as stocks that are beaten down as a result of market conditions, but whose businesses are just fine. For example, during the depths of the financial crisis, AT&T and Verizon were both yielding close to 8%, even though their dividends were never really in jeopardy.
Still, with most high-dividend stocks, you are taking on a considerable amount of risk in exchange for such high yields. And these stocks may prove to be solid long-term investments, if conditions stay favorable. Just know the risks before you buy, so you know what could go wrong, and you can make an informed decision.
Matthew Frankel owns shares of AT&T;, Linn Energy, LLC, and Transocean. The Motley Fool recommends Seadrill and Verizon Communications. 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.