Monday, April 20, 2009

High Yield Stocks and Bonds: A Risky Game

These days it is very easy to find stocks that promise very high dividend yields and bonds that offer apparent sky high returns. Some of these stocks and bonds belong to some of the most prominent companies out there. For example, a quick search on MorningStar yielded the following stocks offering dramatic dividend payments: CitiGroup - 22%; GE - 10%; Pfiser - 8%; Wells Fargo - 6.5%. These are big names offering impressive yields. Are they a good investment?

I don't know the answer to that question, however, there are some key principles that should be considered in connection with such an investment decision. First up, let me say that as far as stocks are concerned - as opposed to bonds - I am of the opinion that dividends do not matter from an investment perspective. I have previously written extensively about the subject, and there is no point in repeating those arguments here. However, even if you believe that high dividends make a stock more valuable, there is good reason to view high yields with suspicion.

Risk / Reward Balance for Bonds - an iron clad law of investing is that higher returns inevitably come with higher risk. This makes sense when you think about it - why would you accept more risk unless someone offered to compensate you for that extra risk? This compensation is the return that you generate. With that in mind, it is pretty safe to assume that a bond that offers a high yield carries with it a high degree of risk.

Dividend Calculation for Stocks - the dividend yield on a stock is calculated by taking the dollar value of the dividend paid for each share, and dividing it by the price of that share. As an example, a stock priced at $100 and paying an annual dividend of $3 has a dividend yield of 3%. The dividend yield on that stock can increase in two ways: the company's board of directors can choose to pay shareholders a higher dividend - say increase the dividend from $3 to $6 thereby doubling the dividend yield to 6%. However, the dividend yield would also increase to 6% if the price of the underlying stock fell by 50% to $50. 

Most stocks that offer the insane dividend yields get there not by increasing their dividends, but by virtue of their stock falling off a proverbial cliff. Now, that in itself may not be a good enough reason to pass on those stocks if you think you know something that the rest of the investment community does not. However, in most cases, there is a good reason why investors show a lack of confidence in a stock by dumping it en masse.

Dividends Are Not Set in Stone - Finally, it is important to understand that there is nothing that prevents a company's board of directors from reducing that company's dividend at any point. In fact, it is a pretty safe bet that a company whose stock is getting crushed will cut its dividend yield: there is typically a sound business reason for a stock to tumble, and it usually involves business problems for the company. In such circumstances it is reasonable to expect a competent board of directors to cut dividends to conserve cash.

Bottom line - high yield seekers beware: high yields are often nothing more than a high risk mirage.

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