The Market's Scariest Highest Dividends

Are you interested in a security yielding 105%? Of course, you are! Who wouldn't be?

I know of another that's yielding 221%. So why settle for just 105%?

At 105%, you'll have your entire investment back in a year -- and in less than six months at 221%.

But if that sounds too good to be true, it is. Oh, those securities are real enough, but despite those eye-bulging yields, you're better off without 'em.

You wouldn't want to touch them with your neighbor's portfolio, because they're Greek bonds. The two-year yield flits around 105%, and the other is the one-year bond.

Those high yields are an object lesson: There's no such thing as a free lunch. But not all high yields are bad, so how do you find the good ones?

Danger! Danger!
A sky-high yield is one of the first warning signs that a stock or bond could be in real trouble. The market doesn't usually offer up megayields unless the security is judged to be extremely risky. In general, the higher the potential reward, the higher the risk.

And that's why you see Greek bonds that seem like they could pave your path to retirement.

But don't buy it, Fool.

A skyscraper yield could also occur because the market doesn't expect the payout to continue for long. That's the case with mortgage REITs such as Annaly Capital (NYS: NLY) and Chimera (NYS: CIM) .

They're paying double-digit yields, and they have done well by investors for the past few years, but that won't last forever. Mortgage REITs thrive in low-interest rate environments, so when the economy starts picking up and unemployment goes down, you can expect the payouts here to dry up. And that will cause their stock prices to swoon.

To be sure, a fat dividend is no guarantee that a stock is doomed, and some high yielders can turn into solid performers over time, as plenty of research indicates. So perhaps the best place to begin is to look for stocks the market's afraid of.

6 scary high dividends
To get a sense of that, I screened for stocks yielding more than 7%, trading on major U.S. exchanges, and having a market cap greater than $1 billion. I came up with just 97 hits. The list is filled with companies that should be trading for high yields: mortgage REITs (two of which you see below), energy-focused master limited partnerships, income trusts, and other stocks the market severely discounts.

Here are some of the notable names and why they're showing scary dividends.

Company

Yield

Scary because...

Annaly 14.6% The high yield will last only as long as the bad times (unemployment, low interest rates)
Chimera 18.2% (See: Annaly)
Telefonica (NYS: TEF) 10.9% More than half of revenue comes from Europe and more than a quarter from beleaguered Spain
Banco Santander (NYS: STD) 10.3% More than half of assets are in Europe and a third in continental Europe.
Frontier Communications (NYS: FTR) 12.8% It runs fixed-line telecom in a mobile world.
CVR Energy Partners (NYS: UAN) 9.5% It IPO'd in April, so little dividend track record. Its growth relies on capital markets. Major finance sites reported no dividend for a while.

 Source: S&P Capital IQ.

Another that didn't make the list because of market cap is Great Northern Iron Ore (NYS: GNI) , which yields 11.6%. The yield is scary because it ends for sure in 2015, when the trust is dissolved.

To get a sense of the sustainability of dividends, it's useful to do a quick check of the following:

  • Net income payout ratio -- to determine what percentage of earnings are paid out as dividends; the free cash flow ratio is a good alternative, too.
  • Dividend growth rate -- you want to see this growing over time.
  • EPS growth rate -- to find a potential growing dividend, you'll want to see this climbing over time.

Here is how the above companies fared:

Company

TTM Net Income Payout Ratio

5-Year Dividend Growth

5-Year EPS Growth

Annaly 184.6% 39.2% NM
Chimera 107.4% NM NM
Telefonica 71.6% 22.5% 14.2%
Banco Santander 26.1% (13.5%) 0.3%
Frontier Communications 466.5% (5.6%) (15.6%)
CVR Partners NM NM NM

Source: S&P's Capital IQ. TTM = trailing 12 months. NM = not meaningful due to lack of sufficient history (CVR and Chimera) or due to prior losses (Annaly).

These metrics give us some basis for evaluating the dividends, but often they don't tell the whole story. And sometimes they can be downright misleading, especially when dealing with non-traditional companies such as REITs, banks, and newly formed MLPs, such as above.

For example, we don't have historical measures due to CVR's limited life, and Frontier's free cash flow (from which it pays dividends) dwarfs its net income, so the 466% payout ratio is misleading. And net income is not an especially useful measure for Annaly and Chimera. For a more traditional business, such as Telefonica, these metrics can work well.

So a more qualitative approach can help flesh these numbers out.

For Annaly and Chimera, low interest rates and high unemployment won't last forever, but the Fed has promised low interest rates until mid-2013. So I have confidence in these players to continue generating the massive dividends. But when rates move up, these dividends will go down.

Telefonica does have huge exposure to Europe, but nearly 60% of its operating profit comes from fast-growing Latin America. Still, nearly a third comes from Spain. Given the regularity of telecom revenue, I'm more bullish on the long-term sustainability and growth of Telefonica.

Banco Santander is right in the crosshairs of the financial crisis, so while its payout is low, banking operations are somewhat of a black box. The Euro crisis is hitting fever pitch, too.

Frontier pays a hefty dividend, but it's had to cut it in recent years, and its cash-cow business -- fixed line telecom -- is facing serious headwinds from the move to mobile telephony. It's hard to see this business thriving in 15 or 20 years.

CVR doesn't put up any numbers in the table, but that's because it recently held its IPO in April. This partnership has a good opportunity in the quick-growing fertilizer business, and its high dividend is more typical for partnerships. Its irregular business could lead to irregular distributions, something income investors don't like much, a fact that could punish the stock.

As for Great Northern Iron Ore, the company will be dissolved in 2015. I don't want to bet that highly volatile ore prices will move in my favor before then.

Foolish bottom line
Because they're often high-risk propositions, the market's highest dividends aren't for everyone. That's why you should consider 11 names from a brand-new free report from Motley Fool's expert analysts called "Secure Your Future With 11 Rock-Solid Dividend Stocks." Today I invite you to download it at no cost to you. To get instant access to the names of these 11 high-yielders, simply click here -- it's free.

At the time this article was published Jim Royal, Ph.D., owns shares Annaly and Frontier. The Motley Fool owns shares of Annaly, Telefonica, and Chimera Investment. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


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Kevin Monroee

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November 10 2011 at 1:01 AM Report abuse rate up rate down Reply