It can be tempting to jump right into a high-yield dividend investment. The prospect of receiving a high (and potentially continuing) income stream might convince you to take much more risk with your money than you're really comfortable doing. High-yield stocks can be a minefield that destroys your capital. Yields that are too high are frequently a sign of a company in major distress -- and of a dividend that's not sustainable.
Still, done intelligently, investing in companies with decent distribution payouts can be a lucrative proposition, despite the risks. If you're going to venture down that path, however, there are five essential facts about high-yield dividend stocks that you should know.
1. Some companies are required to pay out high dividends
Real estate investment trusts (REITs) are required by law to pay out 90% of their income as dividends in order to retain the corporate tax advantages associated with being that kind of company. Key among those advantages: REITs can deduct their dividends as an expense, thus avoiding corporate taxes on the income they generate by passing that along to their shareholders. The downside to shareholders, however, is that REIT dividends are not qualified and thus are taxed as ordinary income.
Many REITs even go beyond that and pay out more than 100% of their income in their distributions. Those excess payments are frequently characterized as either capital gains or return of capital, depending on how the money was generated by the REIT. That portion of shareholders' distributions may receive favorable tax treatment for the recipients compared to ordinary income. Note, however, that those distributions take capital out of the company -- there's no such thing as a free lunch.
2. Not all REITs are created equal
REITs generally come in two types, equity REITs and mortgage REITs. Equity REITs own physical properties, and mortgage REITs invest in mortgages or mortgage-backed securities. Equity REITs are more likely to pay distributions in excess of their reported income levels, as they can shield some of their cash flows from being considered income due to depreciation on their buildings. Equity REITs also have the potential to grow their income over time if they can increase rents on those facilities.
Mortgage REITs tend to have higher dividend yields, reflecting the fact that they're generally very heavily leveraged and are thus exposed to substantial interest rate risk. Especially if interest rates continue to rise, mortgage REITs may see their margins squeezed as their borrowing costs increase while the value of their existing holdings drops.
3. Partnerships may pay out high dividends, too
Publicly traded partnerships are another class of investments that frequently pay high distributions to attract investors. Partnership income isn't taxed at the corporate level, but the entire income of the partnership is taxable income to the partners (shareholders). That holds true when the partners receive a cash distribution or when the partnership retains all of its earnings to grow. As a result, many publicly traded partnerships also pay out all -- or even more -- of their income to their partners as distributions.
Many investors in partnerships are surprised to find out that they may owe state income taxes on the money their partnerships generate from operations. That happens because partnerships are pass-through entities, exposing their partners to the financial details that are typically handled at the corporate level in standard C corporations.
4. Any yield that's too high can be a danger sign
Most dividend-paying companies in an industry tend to have yields within a few percentage points of each other. Those in which the market sees higher growth potential may be on the lower end of the yield spectrum than those judged as steady or even declining businesses. When a company's yield is substantially higher than that of its industry peers, however, it's usually a warning sign that the dividend is considered to be at risk of getting cut.
You won't know for sure until a company announces a dividend cut, but when the market is offering a tempting yield on a company, relative to its peers, try to figure out why. Chances are it's a yield trap and the payout is in danger of shrinking. Things to look out for include a dividend higher than the company's reported earnings or cash flows, an increase in borrowing in advance of dividend payments, and a formerly growing dividend that's suddenly static.
5. Dividends are not guaranteed payments
Even among companies that "have to" pay out high dividends, the requirement only holds true if the underlying business is making money. Any company can cut its dividend if it's not supported by its cash-generating ability, and many businesses will cut their payments to protect their ongoing operations. While the market may punish a dividend cut with a lowered share price, that's usually a better alternative than if the company misses a bond payment.
Bond payments are higher on the corporate priority list than dividend payments, as missing a bond payment triggers default. That can force the company to declare bankruptcy and potentially see its shares wiped out, with ownership transferred to its former bondholders in lieu of the missed payment.
Be careful out there
Especially in today's low interest rate environment, high-yield dividend stocks can appear to be an attractive alternative to bonds for investors looking for income. If you look carefully for businesses that have well-supported dividends and provide their owners with a reason to believe those dividends can continue (and potentially increase), you may find an option that works. For the most part, however, the old saying "if it looks too good to be true, it probably is" still holds true.