Despite the Federal Reserve's insistence that it will continue to raise interest rates, the money you can earn on your money is almost non-existent. The yield on a 10-year Treasury bond is well under 2% and no one expects it to go up anytime soon.
Savers in search of yield – earnings on their money – often look at stock in companies that pay quarterly or monthly dividends. The return is usually a lot more than you can get on a certificate of deposit (CD) and the value of the stock can appreciate. Of course, since it is a stock, its value can also go down.
Still, with Coca-Cola currently paying a yield of 3.11% and AT&T paying over 5%, a lot of investors are willing to take the risk. And with the market's steep sell-off this year, some stocks are recently paying eye-popping, double-digit yields.
But be careful. The dividend yield goes up when the value of the stock goes down – assuming the dividend remains constant.
Here's an example: let's say the stock of XYZ Corp. is trading at about $35 a share and pays a dividend of $1.50 per share. Dividing $1.50 by $35 gives you a nice, solid yield of 4.2%.
But suppose the stock of XYZ Corp. falls, along with the stock market, to $20 a share. Now the yield is 7.5%.
That looks like a great return, but it could be a trap because XYZ Corp. now has what is called an “accidental” high yield. It hasn't increased its dividend -- the yield is high because the price of the stock has fallen, relative to the dividend the company is paying.
That last part is where the trap comes in. If the company's stock has fallen because of declining profits it may not continue to pay a dividend of $1.50 a share. In fact, it can change the amount of its dividend at any time.
It might cut the dividend in half, or stop paying it altogether. That has happened in recent weeks in the energy sector, when oil companies decided they had to cut their payout to shareholders in the face of declining oil prices.
In 2010, when the BP oil rig in the Gulf of Mexico exploded, spilling millions of barrels of oil and exposing the company to huge liabilities, BP eliminated its 8% dividend overnight.
When a company cuts its dividend, the misery just gets worse, because in almost every case, the price of the stock will go down even more. People who bought the stock for the high dividend don't want it anymore when the payout declines or is eliminated.
If you are still holding the stock you purchased for its “accidental” high dividend, not only will you get a smaller yield in the future, you might not be able to sell the stock for some time without incurring a loss.
When considering a dividend-paying stock, investment experts advise always considering the fundamental strength of the company first, investing in stocks you might buy, whether they paid a dividend or not.
Even then, dividend investing is not a buy-and-hold strategy. Investors must remain vigilant to market fluctuations that could affect company fundamentals and future payouts.
Before embarking on such a strategy, make sure you seek the advice of a trusted and objective financial advisor.