Not all dividend yields are created equal.
There are perpetual dangers with high-yield dividend stocks. A high-yield may not be sustainable. A high-yield may be high because a stock’s price is low for a reason. In other words, the company may be struggling and investors recognize it. They sell the stock off and the price drops. Yield moves inversely to price, so a drop in price results in an increase in yield.
That’s why you have to be aware of “value traps” – stocks that seem like they might be values because the price is so low, but are low because the company is struggling and investors have sold it off.
Example: A stock is at $20 and pays a $2 dividend. That’s a 10% dividend. If the stock drops to $10, but the dividend remains the same, now it pays a 20% dividend. What you should be concerned about is why the stock fell from $20 to $10!
You should definitely investigate further if a dividend yield is above 7%.
We happen to be investors at an unprecedented period in the stock market, when the Fed’s quantitative easing has pushed people further out on the risk curve. They are hunting for yields, and companies are trying to cater to them.
The incredibly low interest rate environment has permitted many businesses to obtain cheap money that can be used for high-yield investments, of which most of the income is paid out to shareholders because the company is a REIT or BDC.
There are, however, high-yield dividend stocks that carry risk but less than others with equal or higher yields. I consider these stocks to be relatively safe, for which any decline in stock price or yield as a result of the company’s activities seems unlikely, or will be well-telegraphed.
Four Stocks With Safe 10% Dividend Yields
1. BP Prudhoe Bay Royalty Trust (NYSE:BPT) is, as the name implies, a royalty trust. These companies own oil wells, or possibly mineral rights, for the land that a certain entity is using. This particular trust collects the royalty payments that are based on the amount of oil production from the Prudhoe Bay oil field, which is located in Alaska.
A royalty trust isn’t a business so much as a holding entity that collects and then distributes the royalties that it earns. In this case, it applies to roughly 16% of the first 90,000 barrels of oil produced each and every day. The Trust believes it can pay royalties until 2029, at which time we would expect the value of BPT to be zero.
So you should be fine collecting the 12.3% dividend for at least the next several years, provided oil prices remain relatively stable.
2. American Capital Agency Co. (NASDAQ:AGNC) is what’s known as an mREIT, or mortgage REIT. It purchases residential mortgage securities and collateralized mortgage obligations, for which the principal and interest payments are guaranteed by the federal government.
The good news, then, is that the government will protect the company’s investments in these mortgage securities. The bad news is that mREIT success is tied to low interest rates. AGNC borrows money at these low rates, and then purchases these securities, which yield much higher rates, so they profit on the difference.
If rates increase, then that profit differential shrinks. It also results in a decrease in mortgage REIT values, which drives the stock price lower. However, the Fed has signaled that rates will remain low for awhile, making its 11% yield safe for at least a year.
3. Fifth Street Finance Corp. (NYSE:FSC) is a Business Development Company. It operates in much the same way an mREIT does, but with different risks. It also borrows money at low rates, then lends it out to rapidly-growing small and mid-sized companies at much higher rates.
These rapidly-growing companies have reached a certain point, where cash flow is reliable and strong, yet the company has too much debt on its balance sheet for a bank to feel comfortable lending to it. Instead, it goes to a BDC for financing so it can continue its rapid growth.
FSC recently arranged for $250 million in financing for itself, by issuing unsecured debt at 4.875%, and then lending that money at an average of 10.8%. The risk is trusting FSC’s management to choose the right companies to invest in. SO far, so good, so I’d trust the 10.4% yield.
4. Windstream Holdings, Inc. (NASDAQ:WIN) is an odd duck. It offers managed services and cloud computing services to businesses, as well as broadband, voice, and video services to rural markets. It also sells consumer video services, owns a cable TV franchise, and switching services to long-distance companies.
Telecom plays like this, that are coupled with computing services, and operate in rural areas where the big boys haven’t reached, are compelling plays. Although it carries a ton of debt ($8 billion), it is easily able to service it while turning a nice profit. It returns most of its free cash flow to shareholders, so I think its 10.2% yield is safe and it may even be an acquisition target.
Lawrence Meyers does not have a position in any security mentioned.
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