The Dangerous Reason Why Chasing High Dividend Yields Can Backfire

When it comes to building passive income, it’s easy to focus too much on yield and start favouring high-yield dividend stocks over simply owning high-quality businesses.

That’s understandable. After all, the higher the yield, the more income you’re generating right away. So naturally, a lot of investors get caught up trying to find the stocks that will pay them the most upfront.

However, the problem is that the highest yields are often where the biggest risks are hiding.

That doesn’t mean you should avoid high-yield dividend stocks altogether. But it does mean you need to understand why the yield is high in the first place, because not all high yields are created equal.

Why chasing high yields can backfire

One of the most important things to understand about dividend investing is that yields don’t just rise on their own. They usually increase for a reason, and more often than not, that reason is that the stock price has fallen.

Now, of course, sometimes that sell-off in the stock is simply due to short-term volatility. However, in many cases, stocks see sustained sell-offs because something isn’t going right with the business.

That could be growth slowing down, or debt levels are becoming a concern. Or maybe there’s an increasing risk that the dividend itself isn’t sustainable. And that’s where chasing the yield can become dangerous.

Because if you’re only looking at the income, you can end up buying into a situation where the business is weakening, and the dividend is at risk.

That’s why a lot of high-yield stocks should be approached with caution. Sometimes the yield is simply that high because the stock continues to fall out of favour.

With that said, though, not every high yield is a red flag. In some cases, the yield is elevated simply because of how the business is structured.

For example, certain companies pay out a large portion of their earnings to shareholders, which naturally results in a higher yield.

So, while the income may look similar on the surface, the reason behind that yield can be completely different. That’s why it’s so important to understand the business behind the yield, and how safe the dividend actually is.

When a high-yield dividend stock actually makes sense

High-yield dividend stocks can still play an important role in your portfolio, which is why you don’t need to avoid high-yield stocks entirely. You just need to recognize what’s behind the yield and whether the income is actually supported by the business.

For example, South Bow (TSX:SOBO) is a pipeline stock that operates energy infrastructure assets that generate steady, fee-based cash flow, which already puts it in a similar category as other reliable pipeline and infrastructure businesses.

However, the reason its current dividend yield of 6.1% is higher than many of its peers isn’t that the business is broken.

It’s because it has a shorter track record as a standalone company; it carries more debt than more established names, and it hasn’t started growing its dividend yet.

That’s crucial to recognize because those factors naturally make investors more cautious, which keeps the stock price lower and the yield higher.

But at the same time, the underlying business still generates billions in stable cash flow, with roughly 90% coming from long-term, take-or-pay contracts with investment-grade customers, which helps support the dividend.

So, while there are risks, and every stock has them, they’re very different from the situations you see in certain stocks that actually threaten the dividend.

And that’s why understanding the business and why a yield is where it is is paramount.  Rather than just chasing the highest yield you can find, you determine whether that yield is supported by a durable business model or whether it’s simply a reflection of underlying problems.

In South Bow’s case, the stock only pays out roughly 75% of its distributable cash flow, and as it continues to reduce debt, analysts believe it could transition into a dividend growth stock as early as next year.

That’s why the yield is elevated today. It’s not that the income is at risk, but that the market is still pricing in some uncertainty.

The post The Dangerous Reason Why Chasing High Dividend Yields Can Backfire appeared first on The Motley Fool Canada.

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More reading

• 1 Quarterly Dividend Stock Built to Hold Up in Any Market
• How Putting $50,000 Into This High-Yield Dividend Stock Could Generate $2,988 in Annual Passive Income
• TFSA Investors: Don’t Chase Yield — Do This Instead

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