Dividend focused investors want to earn the highest possible yield, but also want the highest level of safety. At the same time, the higher the yield the market puts on the stock, the more the market believes there is a probability of future dividend reduction. The market may be right about a dividend cut for a high-yield stock, yet there are many higher yield stocks that are able to sustain and even grow their dividend payments.
A dividend cut hits the high-yield investor with a double-barreled shot. First is the reduction in expected portfolio income. Second, in most cases a dividend cut will lead to a severe drop in share price. As a result, an investor cannot sell shares and have enough capital to reinvest in other high-yield stocks to get back the lost income. It is a bad situation all around. While high yield stock dividend cuts are not always predictable, here are three indicators that will allow you to get out of the wrong kind of high yield stocks.
Revenues Going in the Wrong Direction
There is a general rule about any company, which is that if the business is not growing, it is declining. It is nearly impossible for a company to keep revenues and profits at a level amount. This means that even the companies behind your high-yield stocks must be growing. The growth may not always get all the way down to growing dividends, but if you see some level of growth in gross revenue, EBITDA and free cash flow, the dividend is likely secure. If results from a growing business goes flat, you need to watch it closely. Going from some growth to no growth usually leads to negative growth, which will at some point lead to a dividend cut.
A recent example is Windstream Holdings (Nasdaq: WIN) which was yielding 12% before the company suspended its dividend payments when second quarter earnings were released. The WIN share price dropped from over $4.00 per share down to $2.00. Windstream is a traditional telephone service provider, which is a dying industry. The company has not been able to add enough modern telecom services to overcome the declining landline phone service revenues.
The WIN share price crash has also pulled down the share value of Uniti Group Inc. (Nasdaq: UNIT). UNIT earns more than half of its revenue from a landline and fiber assets master lease with Windstream. In the case of Uniti, the company’s revenue and cash flow are growing as it’s rapidly growing its customer base beyond Windstream, and the master lease provides a high level of security for UNIT’s revenues. My analysis is that UNIT will still pay the big dividends that give the stock a 14% yield.
A History of Dividend Reductions
The first time I look at a new-to-me high yield stock, I look at the long-term dividend payment history. If a company has cut dividends several times since the financial crisis, I usually just pass on the stock. I may dig further to see if there are any extenuating circumstances. The business development companies –BDCs – sector is littered with companies that have been forced to cut dividend rates. The rules a BDC operates under strongly reinforces the if a company is not growing, it is shrinking general rule of business. There are just a few BDCs that I would recommend as high yield income investments.
One is Hercules Capital Inc. (NYSE: HTGC), which yields 9.75%. Earlier this year, there was a lot of drama, and a steep share price decline when HTGC proposed a radical management contract change. Management was forced to withdraw its plan. At that time, I recommended buying the stock on the dip. My reasoning was that Hercules was one of the few BDCs to have never reduced its dividend, and whatever changes were made, management would work very hard to not break that record.
Higher Interest Rates
After four years of everyone predicting that interest rates were about to go higher, it appears we have finally reached the actual point in time where rates are going up. The Fed has increased its Fed Funds rate several times, pushing up short-term rates. In the last month, it seems that long-term rates, as indicated by the 10-year Treasury yield, may be finally ready to move above the one-year high of 2.6%. Some companies and high yield stocks will benefit from higher interest rates while others will be hurt. Those in danger will be companies that have a high portion of adjustable rate debt, or have fixed rate debt issued at a lower rate and will need to soon refinance that debt at a higher rate, increasing interest expense. Companies that will benefit are those that issue variable rate debt while their own interest expense will go up slower than the increased interest revenue.
One example is Blackstone Mortgage Trust Inc (NYSE: BXMT), which makes commercial property mortgage loans. Blackstone Mortgage management has stated that the company’s net income per share will increase by about 10 cents for every 0.50% increase in the LIBOR interest rate. BXMT yields 7.9%.
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