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How to build a second income stream with FTSE 250 dividend stocks

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The FTSE 250 (INDEXFTSE:MCX) is often viewed as a growth index. Certainly, a large proportion of its incumbents pay dividends. But it is the index’s capital growth credentials that seems to be the main attraction for many investors.

For example, over the last 10 years the index has generated annualised capital growth of over 8%. That is nearly three times higher than the FTSE 100’s capital growth during the same period. As such, for growth investors, it seems to be the better option.

However, with a number of FTSE 250 shares still offering high yields even after its strong growth of recent years, dividend investors may be able to successfully build a second income stream via the mid-cap index.

Dividend potential

The FTSE 250’s dividend yield of 2.7% may lack appeal for a large number of income investors. Although it is currently ahead of inflation, it is behind the FTSE 100’s income return of 3.9%. As such, the larger index may seem to be the more obvious choice.

However, within the mid-cap index there is a wide range of strong income stocks. For example, there are 14 shares offering yields of 6% or above, and a total of 52 shares with dividend yields of 4% or more. Therefore, there is scope for an investor to build an entire portfolio from FTSE 250 shares and still generate a dividend yield of above 4% per year.

Undervalued?

Of course, for income investors the reliability of shareholder payouts matters just as much as a headline yield. There is little point in having shares in a company with a high yield and a low chance of making dividend payments each year. And with the FTSE 250 consisting of smaller companies than the FTSE 100 that may have less diversity than their larger peers, it could be argued that risk is higher than with the UK’s main index.

While this may be the case, the reality is that there are also opportunities in the mid-cap index. The EU referendum has caused sentiment towards UK-focused shares to come under pressure, and this could create an opportunity for investors to profit. Since a greater proportion of mid-cap shares rely on the UK for their sales than among large-caps, there could be wider margins of safety on offer.

Furthermore, with the FTSE 250 generating capital growth that is significantly higher than the FTSE 100 in recent years, higher risk appears to be more than matched by higher rewards. And since the performance of the UK economy has thus far proven to be stronger than many investors had anticipated following the EU referendum, its outlook could improve over the medium term.

Income prospects

Clearly, the FTSE 100 is likely to remain a major focus for income investors. Large global companies with high yields are hugely tempting for income investors. However, the FTSE 250 also offers stunning income potential for the long term. It may be more volatile than the obvious income stocks of the large-cap index, but could prove to be more rewarding in the long run.

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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.