My article last week about royalty trusts drew a flurry of responses. Frankly, I was a little shocked, especially given how thinly traded these things are. Some wondered which was the best; some asked tax questions; others excoriated me for not explaining key differences between American and Canadian royalty trusts, or any of a dozen other key points.

And more than a few -- in a sign that these high-yield instruments may be in a bit of a bubble -- ripped me for overlooking their personal favorites in my short list. The last time that happened to any great extent was, well, let's say it started with a 19 and ended with a 99.

One stock I mentioned, TEL Offshore Trust (NASDAQ:TELOZ), leapt nearly 20% the very next day -- on 19 times normal volume and no material news. The day after was more of the same, and the stock has only now backed off a little. Apparently, people were enamored with the thought of a 30% dividend yield and chased it, sight unseen. That's a bad plan. When a mere mention in print sends a stock flying, that's another sign of a bubble. What's especially scary is that I said nothing positive or negative about the company.

It is entirely possible (probable, say, to the tune of 100%) that other forces were at play. In light of the dividend tax breaks in President Bush's economic stimulus package, investors are again valuing companies that pay dividends. And since there is nothing like self-interest to compel corporate executives to act, many companies have responded by either offering dividends, or raising them.

In the past few days big banks Citigroup (NYSE:C), Jeffries Group (NYSE:JEF), Bank of America (NYSE:BAC), and Wachovia (NYSE:WB) upped their dividends considerably, as have Qualcomm (NASDAQ:QCOM), Washington Mutual (NYSE:WM), Clorox (NYSE:CLX), and AIG (NYSE:AIG), among many others. Former non-dividend payers like Microsoft (NASDAQ:MSFT) and World Wrestling Entertainment (NYSE:WWE) have jumped on the bandwagon, offering quarterly payouts for the first time in their histories.

Look, Ma, no tax!
Let's take a look at Washington Mutual's dividend to see why the new tax treatment is such a big deal. The company upped its dividend 33% to $1.60 from $1.20 per share. Under the old regime, an investor netted as little as $0.70 of the original $1.20 dividend, depending on the individual's tax rate. Under the new tax regime, while the dividend was raised 33%, that same investor will net $1.36 from the new $1.60 dividend, nearly twice as much.

Is it any wonder investors are running screens to determine which stocks offer the highest yield? In a rational market, dividends offer investors the promise of a regular payment as compensation for holding the company's stock. For years, the dividend payout was a key factor in an investor's consideration of various equities. It was only in the last decade or so that dividends were pushed aside in favor of the rather less reliable promise of greater capital appreciation.

Well, the bloom's off that particular rose, and people are once again demanding to be compensated for their risk in the form of regular dividends. But is the smartest move simply to throw your hard-earned cash at the highest-yielding stocks? Absolutely not. For one thing, particularly with trusts and REITs, where dividends are set by an income-based formula and not a board, these yields are wildly in flux, and, just as often, what you see is not what you get.

Consider TEL Offshore. Many services quote its yield at $1.32 per share -- its most recent quarterly dividend times four. In fact, its trailing 12-month dividend was $0.56 (13 cents, 5 cents, 2 cents, and 33 cents per quarter, respectively), or a much more staid 9.3%. The trust may pay a big dividend again this quarter, or it may not, but counting on a dividend yield implied by a single outsized quarter does not compute. This particular stock -- an income trust -- paid no dividends at one point for more than four years.

Bobbing for yield
So now that the chase is on, what is an investor to do? For one thing, put out of your mind the notion that the higher the dividend, the better, more promising the stock. Think of it this way: If a company paying a 15% dividend happens to trade at $10 per share, it must only fall to $8.50 before the dividend is neutralized by capital loss. There is no such thing on Wall Street as the "Free Money Tree," so remember this, always: "You should assume that companies with big yields have something wrong with them. Always."

By "big yield," I'd use a rough yardstick of 7% per year, somewhat higher for such income-producing equities as REIT's. Companies with outsized yields are being discounted by the market for something. Your job is to find out what that something is. It could be:

  • A loss of confidence in the future of the company (WorldCom, before it went bankrupt, offered a dividend yield in excess of 60%);

  • The dividend is itself at risk (Cable & Wireless (NYSE:CWP) recently canceled its dividend due to continued market sluggishness);

  • The payout ratio (dividend as a function of net income) is too high;

  • A high-risk event like a lawsuit, loss of contract, or loss of top customer. (Altria's (NYSE:MO) continuing legal woes keep its stock depressed far below where its cash flows would otherwise warrant.)

More often than not, the dividend gets to be so high as a percentage of the company's stock price because the market has determined that things are not rosy. The market may be wrong -- it has been many times before -- but you should go into one of these investments with full knowledge of what the market thinks is amiss.

Tread lightly
My advice is that you treat high-yield stocks gingerly. Giving up a few points in yield to get into a much higher quality company with a better risk-reward profile is generally the more conservative, better way to go unless you have real reason to believe that the market is wrong about a particular security.

After all, 9% sounds a heck of a lot better than, say, 6%. And all things equal, you should take that 3% every time. All things are rarely equal, however. If it means risking a loss in principal, chasing that yield could end up being very expensive.

Fool on!
Bill Mann, TMFOtter on the Fool discussion boards

Really, now! Bill Mann owns shares of Cable & Wireless and Wachovia. The Motley Fool is investors writing for other investors.