26 Mar Avoid dividend yield traps
Investors, especially those focused on receiving income, are sometimes lured by high company dividend yields.
After all, dividend yields can be an indicator for which listed companies are paying out good dividends.
Yet, investors seeking out dividends, especially from companies that currently appear to be paying attractive dividend yields, should be extremely careful.
What may look like a good yield opportunity may not pan out that way over the medium term. In fact, in terms of dividend income, a high dividend yield is not necessarily an indicator that a company has any capacity to pay out a future dividend. It may be because of a decline in the share price rather than because of a strong, consistent dividend payment.
The spike in yields
Right now, the notional dividend yields on many companies listed on the Australian Securities Exchange (ASX) may look attractive.
Dividend yields are calculated by dividing a company’s prevailing share price by its declared annual dividend payment per share. Yields move constantly, in tandem with share prices.
If a company’s price falls significantly, the dividend yield can appear very high. However, this high yield might be a sign of underlying problems with the company.
One ASX company, for example, was trading with a dividend yield of more than 30% at 14 March, 2025. More than two dozen others were trading with dividend yields of between 8% and 10%.
Yet, keep in mind that the share prices of most of these companies have fallen sharply over the last year, several by 20-30%. Their high dividend yields directly correlates with the plunge in their respective share prices.
The easiest way to reduce dividend income risk – the risk of being over-exposed to the payout policies of specific companies – is through diversification.
Dividend payments can change
One of the fundamental investment lessons for income-focused investors is that dividend payments are not locked in stone.
In the same way that dividend yields, especially during volatile trading conditions, can gyrate wildly from day to day, company dividend payments can be cut, increased, or stay the same.
Some companies in financial trouble may maintain or even increase their dividend payments to attract investors, but this can be a sign that the company is struggling to generate sufficient cash flow.
The just-ended February company reporting season saw a number of Australian companies trim their dividend payouts. Difficult operating conditions, even ahead of the latest market downturn, were largely to blame.
Certain sectors often have higher dividend yields, but these can be more vulnerable to economic downturns or regulatory changes.
Signs to watch for
High Debt Levels: Companies with high debt levels may struggle to maintain dividend payments.
Declining earnings: Consistently declining earnings can be a red flag, indicating that the company may not be able to sustain its dividend.
Payout ratio: A high payout ratio (dividends as a percentage of earnings) can indicate that the dividend is not sustainable.
Industry trends: Negative trends in the company’s industry can affect its ability to maintain dividends.
Reducing dividend income risk
It’s always important to undertake thorough research on a company’s financial health, including its earnings, debt levels, and cash flow. That will be a good indicator of its capacity to pay out dividends.
Monitor the company’s performance and any changes in its dividend policy.
However, the easiest way to reduce dividend income risk – the risk of being over-exposed to the payout policies of specific companies – is through diversification.
And the best way of achieving that is by having broader exposures to diversified income streams via a large pool of listed companies, such as though an exchange traded fund (ETF) and/or a managed fund covering the largest companies in a single market or across multiple markets.
Think of funds as a form of fishing net that will catch the dividends of very company that falls into their investment focus, for example every company that’s contained within the S&P/ASX 300 Index.
The key advantage for investors is that irrespective of individual company dividend yields and payouts, a fund will aggregate all dividends and distribute them to investors.
While dividend flows may decline over them medium term, having exposure to many companies allows investors to capture a greater amount of the total dividends spectrum.
Doing this also eliminates the need to focus on the dividends of individual companies and their dividend yields, which recent events have proved can be a dangerous trap for investors.
Our investment team is ready to help you accomplish your financial goals and needs. Feel free to send us an email at info@centrawealth.com.au or give us a call at 08 82314709.
Article courtesy of Vanguard.
