When Dividend Stocks Appear Too Good to Be True
It is a foregone conclusion, in my view, that rates will rise substantially in the coming years. It's just a matter of when. When that happens, bond owners will see the value of their holdings drop; the longer the term, and lower the coupon, the greater the damage. That is simple bond math, and it is the reason many pundits are advising that the duration of bond portfolios be shortened.
But owners of dividend-paying stocks face their own share of risks. There's always market risk; stock prices can fluctuate wildly. There's plenty of evidence to suggest that high-quality dividend-paying stocks face a lower level of price volatility, and that the dividend may help put a price floor in place. It is unlikely that a high-quality name yielding 4% will see its price cut in half, at least for very long, assuming the fundamentals are intact, and that there's not trouble brewing specific to that company or industry. If the story is intact, theoretically, new buyers will emerge, taking advantage of the now 8% yield, pushing the price higher and the yield lower.
One of the greatest risks to those seeking yield through dividend-paying stocks is the possibility that the dividend is either reduced or eliminated. That is typically a signal that all is not well with the company, but there are often warning signs that investors should be aware of. Ultimately, dividend cuts or eliminations are rarely a surprise when announced.
Declining earnings and rising dividend payout ratios can indicate that a cut may be coming. A disappointing quarter or two, where the overall story and fundamentals remain intact is typically not cause for panic. But a sustained rise in payout ratio, declining earnings, rising debt level, and decreasing liquidity should not be ignored; especially if the company is in an industry that is struggling or in decline.
Yields that appear too good to be true are another potential red flag. That signals that the market is expecting a dividend cut, and pricing in that reduction. The market is not always right, but in my experience, if the dividend appears too good to be true, and that's the only reason you are buying a particular name, it's time to take a step back and review the situation.