Does High Yield Mean High Risk?

Why would some dividend stocks yield 8% while others yield 6%, 3%, or even 1%? Are higher yield stocks riskier? The answer is not as simple as a “yes” or “no”.

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The risk in investing in stocks

First, let’s define “risk”. Some define risk as “volatility” — the more ups and downs a stock experiences, the higher risk it’s perceived to have. Volatility is often associated with “beta”.

If a stock has a beta of 1 when the stock market goes up by 1%, the stock goes up by 1%, and if the market declines 1%, the stock also declines 1%. Oh, and the beta changes over time. (So, use that metric as a reference and don’t bet on it too much.)

I think the true risk of investing in stocks is selling at a loss. For some people, it’s difficult to hold on to volatile stocks because they can’t bear to see their investments going up or down too much. So, volatile stocks are risky for those people. (But stocks are inherently volatile because they trade on the market…but that’s a topic for another day.)

The risk in investing in dividend stocks

When you buy dividend stocks, you, of course, expect its dividend to be safe. But as we know, occasionally, stocks do cut their dividends. So, a dividend stock that’s risky would have signs indicating it might cut its dividend.

There are some things you can check to know if a dividend is safe — at least comparatively speaking.

Does high yield mean high risk?

Going back to this question, is a high yield stock necessarily riskier than a lower yielding stock?

No one can answer you unless they know which stock it is. When checking for dividend safety, it must be determined on a case-by-case basis.

Here we’ll use Dream Office Real Estate Investment Trst (TSX:D.UN) as an example. Before the office real estate investment trust (REIT) cut its distribution by a third (this year), it yielded as high as 15% last year. Even now, after the distribution cut and price decline, Dream Office still yields 8%.

Is the REIT’s distribution at risk? After the distribution cut, its payout ratio is lower and is more sustainable. So, its distribution has a bigger margin of safety than before. The distribution cut and price decline also make it a lower-risk investment.

That said, Dream Office’s cash flow is likely to trend lower because in February the company announced its intent to sell $1.2 billion of its non-core assets over the next three years with the aim of drawing out value because its shares are trading at a double-digit discount from its net asset value.

Some of the sale proceeds from the non-core properties will be used to reduce its debt and to strengthen its balance sheet, which means those proceeds won’t go into buying new assets and its cash flow will probably decline.

Conclusion

At the end of the day, high yield or not, whether a dividend is safe or not comes down to if the board decides to cut the dividend or not.

However, a company — whether it offers a low yield or high yield — pays a safer dividend if it has all four attributes below.

  • It tends to grow its earnings or cash flows
  • It tends to hike its dividend every year
  • It has a sustainable (if not low) payout ratio
  • It has sustainable (if not little) debt

Generally speaking, companies that pay small yields to yields of up to 5% with the above attributes offer dividends that are relatively safer than a no-growth company that pays a high yield.

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Disclosure: At the time of writing, I don’t own any shares in companies mentioned.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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