Many different types of high dividend stocks exist in the market, and each type possesses unique benefits and risks.
Here are some of the most popular places to find higher-yielding dividend stocks:
Real Estate Investment Trusts (REITs):
REITs were created in the 1960s as a tax-efficient way to help America fund the growth of its real estate. Like MLPs, REITs are pass-through entities that pay no federal income tax as long as they pay out at least 90% of their taxable income as dividends.
There are over a dozen different types of REITs (e.g. apartments, offices, hotels, nursing homes, storage, etc.), and they make money by leasing out their properties to tenants. Their high payout ratios and generally stable rent cash flow make them a very popular group of higher dividend stocks. Master Limited Partnerships (MLPs):
MLPs were created by the government in the 1980s to encourage investment in certain capital-intensive industries. Most MLPs operate in the energy sector and own expensive, long-lived assets such as pipelines, terminals, and storage tanks. Many of these assets help move different types of energy and fuel from one location to another for oil & gas companies.
MLPs can pay high dividends because they do not pay any income taxes (you pay taxes on your share of the MLP’s income instead), pay out almost all of their cash flow in the form of cash distributions (the MLP equivalent of corporate dividends), and generate fairly predictable earnings in many cases.
Business Development Companies (BDCs):
BDCs were created in 1980 and are regulated investment companies. They are basically closed-end investment funds that are structured similarly to a REIT, meaning they avoid paying corporate taxes if they distribute at least 90% of their taxable income in the form of dividends.
There are many different types of BDCs, but they ultimately exist to raise funds from investors and provide loans to middle market companies, which are smaller businesses with generally non-investment grade credit. Roughly 200,000 of these businesses exist, and large banks are less likely to lend them growth capital, which is why BDCs are needed.
Closed-end Funds (CEFs):
closed-end funds are a rather complex type of mutual fund whose shares are traded on a stock exchange. Its assets are actively managed by the fund’s portfolio managers and may be invested in stocks, bonds, and other securities. The majority of CEFs use leverage to increase the amount of income they generate, and CEFs often trade at premiums or discounts to their net asset value, depending largely on investor sentiment.
a relatively new class of high dividend stocks, YieldCos are pass-through entitles that purchase and operate completed renewable power plants (e.g. wind, solar, hydroelectric power), selling the clean energy they generate to utility companies under long-term, fixed-fee power purchase agreements.
Utilities & Telecom Sectors: utility and telecom companies are generally mature businesses with low growth rates. As a result, many of them return the majority of their cash flow to shareholders in the form of dividends, resulting in attractive yields.
The Highest Dividend Stocks Can Be Risky
After reading through the different lists above, you might have noticed that most high dividend stocks are not your basic blue-chip corporations like Coca-Cola (KO) and Johnson & Johnson (JNJ).
Instead, many of them have unique business structures and risks to consider.
Take REITs and MLPs, for example. Since these high yield stocks distribute almost all of their cash flow to investors to maintain their favorable tax treatments, they must constantly raise external capital (i.e. debt and equity) to grow.
Realty Income (O), one of the best monthly dividend stocks, has nearly tripled its shares outstanding since 2008.
On the other hand, a business like Johnson & Johnson can use the free cash flow it generates to pay dividends while still retaining plenty of funds to reinvest in new projects, growing earnings and dividends along the way (without needing to issue equity or new debt).
Since REITs and MLPs need to issue debt and sell additional shares to raise the money they need to keep growing their capital-intensive businesses (buying real estate and constructing pipelines isn’t cheap), they face additional risks compared to basic corporations.
If access to capital markets becomes restricted or more expensive (e.g. rising interest rates; a slumping share price), such as what happened during the financial crisis, these types of high dividend stocks can suddenly be very vulnerable.
Kinder Morgan (KMI), the largest pipeline operator in the country, is perhaps the most notorious example in recent years.
The company slashed its dividend by 75% in late 2015 as outside financing became too costly, forcing the company to pick between investing for growth and maintaining its dividend.
Ferrellgas Partners (FGP), a major retail distributor of propane, is another example of the risks certain high dividend stocks can pose.
While the MLP had been in business for more than 75 years and paid uninterrupted dividends since 1994, it stunned investors in 2016 by slashing its distribution by more than 80%.
Ferrellgas Partners took on too much debt to diversify its business in recent years, and mild winter temperatures drove down propane sales, causing a cash crunch.
Simply put, high payout ratios and high financial leverage elevate the risk profile of many high dividend stocks.
A seemingly stable company can become dangerous in a hurry if unexpected hiccups surface.
In addition to their dependence on healthy capital markets, certain high dividend stocks such as REITs and MLPs also face regulatory risks.
For example, if Congress decided to change the tax treatment for MLPs, those businesses might not be able to avoid double taxation.
BDCs and CEFs contain their own unique risks, too. By employing meaningful amounts of financial leverage to boost income, any mistakes made by these high dividend stocks will be magnified, potentially jeopardizing their payouts.
If something appears too good to be true, it often is (eventually). Not surprisingly, many of the highest paying dividend stocks can also be value traps.
GameStop (GME) is one example, at least before it became the posterchild for meme stocks in 2020. The company has been in business since 1994 and operates thousands of retail stores that primarily sell new and used video game hardware and accessories.
GameStop is a basic corporation, not a REIT or MLP, but its stock yielded well over 10% in early 2019. However, the company proved to be a dividend trap rather than a high yield bargain.
GameStop’s sales had struggled in recent years as customers have increasingly favored digital game downloads, and the company’s profitability was steadily deteriorating.
Management took on increasing amounts of debt to diversify the company into more attractive markets, but the clock was ticking on its turnaround.
With results remaining weak, management suspended GameStop's dividend in June 2019. GameStock's stock price was down more than 75% from its 2017 high.
At the end of the day, high yield investors need to do their homework and make sure they understand the unique risks of each high dividend stock they are considering – especially the financial leverage element.
Maintaining a well-diversified dividend portfolio is an essential risk management practice. Before piling into REITs, for example, consider that the Real Estate sector only accounts for roughly 3% of the S&P 500’s total value.
There are some very good REITs out there, but most things are better in moderation. You just never know what could happen, especially as we potentially begin exiting this period of record-low interest rates.
Safe High Dividend Stocks: What to Look For
While the risks of owning certain high yield dividend stocks are hopefully clear, there are several steps investors can take to pick out the safest ones.
First, it goes without saying that you should never buy any investment that you don’t understand.
Warren Buffett refers to this concept as staying within one’s circle of competence.
Many high yield stocks are unfortunately just too complicated for me to own them in my dividend portfolio.
Once you have identified a stock that you understand fairly well, you need to evaluate its riskiness.
Some of the biggest risk factors to be aware of for a stock are: (1) the industry it operates in; (2) the amount of operating leverage in its business model; (3) the amount of financial leverage on the balance sheet; (4) the size of the company; and (5) the current valuation multiple.
Collecting the information needed to gauge how risky a high yield dividend stock is can be a time-consuming process.
That’s one reason why we created Dividend Safety Scores, which scrub through a company’s financial statements to evaluate the safety of its dividend payment.
Dividend Safety Scores can serve as a good starting to point in the research process to steer clear of high yield traps.
Investors can learn more about how Dividend Safety Scores work and view their real-time track record here
We used our Dividend Safety Scores to help identify some of the best high dividend stocks
for conservative income investors.