A 9.8% Yield That Looks Attractive – Here’s Why It Could Be a Dividend Trap

When a stock starts offering a yield approaching 10%, it immediately grabs investors’ attention.

And in today’s market, with so much uncertainty and volatility, that kind of yield can look incredibly tempting for income investors.

But that’s also exactly when you need to slow down. Because when yields are that high, it’s almost always a direct result of the stock price falling rapidly and significantly.

And stocks don’t just fall for no reason. That’s why a high yield isn’t automatically a bargain. In many cases, it’s the market signalling that something isn’t right.

That doesn’t mean every high-yield stock is a dividend trap. But it does mean investors need to understand why the yield is elevated in the first place, which is why Telus (TSX:T) is a stock to keep an eye on.

Right now, the stock is offering a yield that looks extremely attractive on the surface, especially from a stock and industry that have traditionally produced excellent income investments.

So the real question investors need to figure out is whether Telus is a true dividend trap, or if the market has simply become too pessimistic.

Why investors are worried about Telus and its dividend yield

There’s no question that the telecom sector in Canada has become a much tougher environment over the last few years.

Competition has intensified, and at the same time, slowing immigration growth is making it harder for telecom companies to rely on steady subscriber increases.

That combination has raised concerns that long-term growth in the industry may not be as strong as it once was.

On top of that, Telus and its competitors have spent years investing heavily in fibre and network expansion in a telecom arms race, which has left it with a significant amount of debt.

So, now, instead of aggressive expansion, the priority has shifted to reducing leverage and improving the stock’s financial situation.

That’s important because investors are already worried about the sustainability of Telus’ dividend at these levels, so if the stock struggles to meaningfully pay down its debt over the next few quarters, the payout could be under serious pressure, which is a big reason it has sold off so significantly and sent its yield soaring.

Because if Telus struggles to bring down its debt quickly enough, the dividend could eventually come under pressure.

And that’s a big part of why the stock has sold off. It’s the result of real concerns around slowing growth, rising competition, and the company’s balance sheet.

Why some investors still believe the telecom stock can maintain its dividend

With all of that said, there are also signs that Telus could turn this around before needing to trim the dividend.

For example, Telus recently reported a roughly 19% year-over-year increase in free cash flow to about $583 million, while reaffirming its full-year guidance of around $2.5 billion.

So not only is that a significant improvement, but it also suggests the company may be moving past the most capital-intensive phase of its fibre buildout.

And as those investments slow, more cash can be directed toward supporting the dividend and reducing debt. That’s the key transition investors are watching.

With that said, though, short-term improvements in its free cash flow do not mean the risks have disappeared.

The recovery still depends heavily on Telus reducing its debt over the next few years to strengthen its balance sheet and financial position.

The Foolish takeaway

When dividend yields get this high, you don’t want to blindly chase the income, but you also shouldn’t dismiss the stock right away. Instead, the best approach is to understand what the market is pricing in.

Because while these situations can be red flags, they can also create long-term opportunities for investors who see the bigger picture.

Telus could certainly prove to be a recovery story if free cash flow continues to improve and the balance sheet strengthens. But the risks around growth and leverage are still significant.

And that’s what matters most to investors right now because at this point, it’s not just about the yield, it’s about whether the business can actually support it over the long haul.

The post A 9.8% Yield That Looks Attractive – Here’s Why It Could Be a Dividend Trap appeared first on The Motley Fool Canada.

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More reading

• How to Use Your TFSA to Average $1,538 Per Year in Tax-Free Passive Income
• Beyond Telus: A High-Yield Stock Perfect for Income Lovers
• A Value Stock With a Dividend Yield Over 9% to Buy Near 52-Week Lows
• Why I’d Choose This Dividend Stock Over Telus or BCE Any Day
• This TSX Dividend Stock is Down 24% and Worth Holding for Decades

Fool contributor Daniel Da Costa has no position in any of the stocks mentioned. The Motley Fool recommends TELUS. The Motley Fool has a disclosure policy.