It's a given that retirees and near-retirees often have a strong interest in dividend-paying stocks, as they're looking at lives without paychecks and need new income streams. All dividends aren't created equal, though, and some very tempting ones are often best avoided. Here are three examples -- companies that recently sported hefty dividend yields of 8.4%, 13%, and 4.7%.
Dan Caplinger: The plunge in energy stocks over the last year has awakened my value-investing instincts. Oil prices are looking to hit bottom, and stocks such as ConocoPhillips ( COP 2.39% ) have fallen to such attractive levels that it's tempting to try to jump in and catch a falling knife. In particular, ConocoPhillips' current dividend yield of about 8% is especially interesting for retirees looking for income from their portfolios.
The problem, though, is that many of those following oil stocks now believe that ConocoPhillips will cut its dividend in the near future. The oil giant needs to figure out how to manage its current debt, and plans for asset sales could help the company strengthen its balance sheet. Yet even if debt weren't an issue, one could argue that ConocoPhillips should retain its capital in order to find opportunities to make strategic moves such as targeted acquisitions. That might be good news for many shareholders, but retirees counting on that high yield would be greatly disappointed. On top of that, the stock price could fall further even after its 28% drop in 2015 followed by a decline of more than 15% in January. For now, the risk-reward profile for ConocoPhillips doesn't make it worth it for the typical conservative retiree investor.
Matt Frankel: Mortgage REITs (real estate investment trusts) such as Annaly Capital Management ( NLY 2.20% ) may look tempting with their double-digit yields -- Annaly recently yielded a whopping 13%! -- but they aren't good investments for retirees. When investing in retirement, safety and predictability are more important than the dividend yield itself, and Annaly offers neither of these things.
The basic business model of mortgage REITs is to borrow money at short-term interest rates to buy mortgage-backed securities that pay higher long-term interest rates. The difference between the two rates represents the company's profit. To produce such high yields, these companies use a great deal of leverage. In Annaly's case, the current ratio is 5.8-to-1, meaning for every dollar in equity, the company has $5.80 in assets on the books.
The problem is that if interest rates don't cooperate, profits can disappear quickly. For example, let's say you borrow money on a short-term basis at 2% interest to buy a 30-year mortgage paying 4%, so your spread is 2%. However, if short-term rates spike to 3%, your profit margin will be cut in half. If they spike to 4%, your investment will simply break even. If they spike even higher ... well, you get the idea.
As of the most recent quarterly report, Annaly's average yield on its interest-earning assets was 2.41% and the average cost was 1.65%, which translates to a spread of 0.76%. So, it's easy to see how, in the wrong interest rate environment, things could go downhill for shareholders quickly.
Of course, there is more to the mortgage REIT business than this, and these companies do have ways of hedging their bets, but these companies and their dividends are far too volatile for most investors, especially retirees.
Selena Maranjian: Philip Morris International ( PM 2.25% ) might seem like a perfect stock for retirees to buy, not avoid. After all, it pays a solid dividend that recently yielded 4.7% and that has been increased by an annual average of 10% over the past five years. It has averaged returns of 13% over that period, too. What's not to like?
Well, that dividend growth rate is slowing, for one thing. The last increase was just 2%, and the one before that 6.4%. Meanwhile, the company's payout ratio, reflecting the percentage of earnings taken up by dividends, has been rising, recently surpassing 85%. The higher the payout ratio, the less room there is for a company to comfortably increase its dividend -- and ratios above 100% aren't sustainable over the long run.
Philip Morris is facing a lot of headwinds. While its net profit margins are fat, recently topping 25%, its top line has been shrinking over the past few years. The company is focused on selling tobacco products abroad (including those featuring the powerful Marlboro brand), but just as happened in the U.S., regulation and taxation of tobacco has been increasing internationally -- though Philip Morris is suing some countries for doing so. Meanwhile, there are other legal clouds, too, with Thailand accusing the company of tax evasion -- which could possibly cost it upwards of $2 billion. There's simply too much uncertainty here for retirees.
Retirees -- and all investors, for that matter -- need to choose their investments carefully. Don't grab a fat dividend without doing your diligence.