Ultra-high dividend yield stocks are oh-so-tempting. Who wouldn’t want an 18% income? I know I would. But in my experience, extreme caution is needed when buying such shares. The risk of a dividend cut is often higher than usual.
Today I’m going to look at two of the FTSE 100’s biggest miners, Rio Tinto (LSE: RIO) and BHP Group (LSE: BHP). These stocks have forecast dividend yields of 18% and 12% respectively for the current financial year. Should I consider buying these shares for my income portfolio?
What’s been happening?
Thanks to their giant mines in Western Australia, Rio and BHP are able to produce more iron ore, at lower cost, than almost anyone else. Much of this raw material is exported to China. It’s used for steelmaking, often for the construction industry.
When the pandemic struck last year, a surprising thing happened. From April onwards — as life began to return to normal in China — demand for iron ore surged. The price rocketed. Between April 2020 and June 2021, the iron ore price rose from about $80 per tonne to a high of around $210 per tonne.
Throughout this period, Rio and BHP were producing iron ore at a cost of less than $20 per tonne.
You can imagine how profitable this was. BHP’s net profits rose by 42% to $11.3bn over the 12 months to 30 June. Rio’s net profit rose by 119% to $17.2bn over the same period.
Why things are changing
Although strong copper prices have also helped, Rio and BHP both generated about 80% of their profits from iron ore over the last year.
Unfortunately, market conditions are changing. With Chinese property developer Evergrande seemingly at risk of defaulting on its debts, the market is worried that demand for iron ore will fall. If China stops building so much, it could have a significant impact on global demand.
Since the end of July, the iron ore price has fallen by 42% to $120 per tonne. At this level, Rio and BHP are still very profitable. But profits will be much lower than they were over the summer period, when prices were over $200/tonne.
Dividend outlook: what happens next?
The latest consensus forecasts suggest that Rio will pay total dividends of $11.84 per share for 2021. With the shares trading at 4,840p, that gives a yield of around 17.5%.
BHP is expected to pay out $3.06 per share, giving a forecast yield of 11.8%.
I suspect that this year’s payouts will be a little lower than expected. But what really worries me is the outlook for 2022 and 2023. Unless we see another huge price spike in iron ore, or perhaps copper, my sums tell me that both Rio Tinto and BHP are likely to make much smaller dividend payouts from next year.
Broker forecasts support this view. The latest estimates I can find suggest that by 2023, Rio’s dividend will have been cut by 50% to around $5.80 per share.
It’s a similar story for BHP, whose dividend is expected to fall by about 45% to $1.60 per share over the next couple of years.
Rio and BHP shares have been falling in recent weeks. But they’re still close to historic highs. I think there’s further to fall, so I won’t be buying either of these FTSE 100 stocks right now.
