Don’t treat Dividend Paying Stocks like Bonds! 3

A generation ago, income seeking investors looked to bonds for safe and stable income payments. This made sense as investors could easily get a safe yield of 8% or higher. But in todays low interest rate environment, bonds are not attractive for income seeking investors. This is especially true for retirees who traditionally tend to hold the majority of their portfolios in bonds as they need the income today. 10 year bond yields are currently yielding about 2%. This means that you need to have £2,000,000 invested just to generate an income of £40,000 a year.

As you already know, this is a huge problem. Most retired investors don’t have £2,000,000 to invest! According to recent statistics, most people don’t even have one tenth of that!

So with Bond Yields at historic lows, many people have turned to other sources to generate income in their portfolio. And in order to do so, they are committing that cardinal sin of investing: They’re chasing yield in high-dividend-paying stocks.

Say for example you find a stock yielding a very healthy 10% dividend. You can generate that same £40,000 with £400,000 invested. That’s still a lot of money but it is a huge difference to the amount needed when invested in bonds.

Now here is the problem, many are treating income from dividends as being as safe as income from bonds!

Remember, bond interest is a contractual obligation. If the bondholder doesn’t pay you, you can sue them. And if they fall into bankruptcy, you are first in line to get paid. Have a read at this article to find the pecking order during a bankruptcy. As you will see bond holders are at the top and equity owners are right at the bottom.

On the other hand, a company has no obligation to pay out dividends. A company can cut its dividend at any time at the discretion of the board of directors. And as an investor, there’s not a thing you can do about it.

The truth is that dividends get slashed all the time. According to Street Insider, 837 companies have cut or eliminated their dividend in this year alone, including large players like Tesco and Glencore. As recently as August, Glencore was yielding a very fat dividend of nearly 9%. Well, that was before they slashed their dividend payments to 0. Earlier this year, the payout was £0.12p per share. The same thing has happened to Tesco just showing that you cannot rely purely on stocks, even blue-chips, for income in your portfolio.

Now I’m not going to tell you to dump all of your dividend-paying stocks. But I am telling you not to think of dividend income being a certainty and that you need to think differently about dividends.

When looking at dividend paying stocks, longevity and growth are far more important than current yield. The longer a stock has paid a dividend, the less likely it is that that dividend will be cut. There can always be a crisis that comes out of the blue – think the 2010 Gulf of Mexico oil that made BP cut its dividend payout. But if a company has managed to pay and grow its dividend for multiple consecutive decades, this is a company that is likely to continue paying dividends, even through minor turmoils.

Another important point to consider when looking at the dividend paying stocks is the payout ratio. This is the amount of total profits that is paid out of the profits of a firm. A healthy company should be paying out considerably less in dividends than it takes in as earnings and cash flow. It’s not sustainable for a company to pay out more than it takes in like a number of companies are doing at the moment. It is interesting that many investors never look at this figure and get tempted into buying these stocks only for the company to later slash the dividend payout which would also cause the stock price to fall. A double whammy if there ever was one!

So if you have to take anything from this article, take the following:

  1. Don’t treat dividend paying stocks (even blue-chip companies) like bonds – Dividends are far riskier than bonds
  2. Don’t chase yield – focus on companies that have a long history of increasing dividend payout rather than what the current dividend yield is at the moment.
  3. Look at the Dividend payout ratio – a company can’t pay out more than it takes in forever.