High-yield dividend stocks have always been around, offering tasty payouts to brave income investors. But following the 2022 stock market correction, the list of shares offering yields in excess of 6% has grown substantially. And looking at the FTSE 350 today, over 70 companies are providing some chunky-looking dividends.
This isn’t entirely surprising. After all, when stock prices drop, yields go up. And considering we haven’t seen such downward share price momentum since the 2008 financial crisis (excluding the short-lived market crash in 2020), investors now have the rare opportunity to snatch up some passive income not seen in over a decade.
Capitalising on depressed valuations
High-yield stocks are an intriguing concept. After all, providing a company can maintain its dividends, earning a 6%, 7%, or even 8% return on investment solely through dividends year-on-year can create massive compounding returns.
Under normal circumstances, maintaining such enormous payouts is exceptionally difficult. In fact, high yields of this magnitude are usually a red flag of an impending dividend cut. But when seemingly all shares have jumped off a cliff due to panicking investors, inspecting these yields more closely can reveal exciting opportunities.
A firm whose valuation has tanked despite cash flow remaining intact and maybe even in growth mode is not uncommon during periods of volatility. That’s because most decision-making is determined by an emotional bias called loss aversion rather than sound logic.
I think the commercial real estate sector is a prime example of this. The rising concerns surrounding the occupancy of office buildings in the face of remote working solutions are creating cash flow issues for some real estate firms.
But it seems investors are also applying this fear to other groups, including self-storage and logistics warehousing firms that are actually seeing increased demand and achieving growth. Consequently, share prices are dropping, yield is rising, and dividends keep growing. Needless to say, that’s a lucrative combo.
The hidden risks of high-yield stocks
Investigating whether dividend payments can be sustained and grown in the long run doesn’t stop in the financial statements. Investors need to pay attention to other external factors that could be directly or indirectly affecting the longevity of a firm’s earnings.
Looking back at the real estate example, something that’s potentially problematic is rising interest rates. Commercial landlords are often dependent on mortgages to expand their investment portfolio. With rates increasing, the cost of this debt has jumped considerably over the last 12 months.
Let’s assume the continued growth in rental income covers this higher financing cost without taking a bite out of dividends. While that certainly sounds like a good situation to be in, that may not be the case. Any existing debt could likely be paid off without much trouble. But new debt will be needed if a firm wants to continue to expand its real estate empire. And that’s going to be far more expensive to service.
Consequently, future growth could be far more challenging. And if a more nimble and well-funded enterprise comes along, expansion opportunities could be snatched away in the future, eventually compromising shareholder payouts. Therefore, investors must carefully investigate the risks before pursuing high-yield investment opportunities.
