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Kiersten Essenpreis for Money

With interest rates near record lows, trying to live off investment income isn't easy. Dividend yields — which rise as stock prices fall — can seem like a tempting alternative. But the strategy is a risky one.

Fears of the coronavirus have beeing weighing on stock prices. As a result, payouts on some prominent companies have reached eye-popping levels. As of April 30, Exxon Mobil's yield was 7.3%, Simon Property Group's 12.2%, The Gap's 10.7%, and Invesco's 7.2%.

Historically speaking, yields like those are largely unheard of. To put that in context, the average dividend yield of the S&P 500 at the end of March was 2.2%, and the long-term average of the last 25 years is 1.9%, according to Venice, Fla.-based dividend experts Ned Davis Research.

Now compare those dividend yields to other possible parking spaces for your money: 10-year Treasuries, for instance, are bottom-scraping at 0.6%.

So not only do dividend stocks offer yield, but investors benefit from potential long-term stock-price appreciation, as well. Tread carefully, though: High-yield equities are something of a minefield, especially now, and you have to pick your way through them with extreme care.

“It’s more important than ever to do your homework and determine if a dividend is safe,” says Ed Clissold, chief U.S. strategist for Ned Davis Research. “Many companies will cut or suspend their dividends, so the current yield isn’t reflecting the income investors are actually going to get.

“But in other cases, the dividend is safe – and this is a rare opportunity to lock in a healthy yield.”

Remember the lessons of 2008

The variable here is that dividend yields are never written in stone, but can be paused, trimmed or eliminated in times of economic distress. To wit, in the financial crisis of 2008-2009, the number of S&P 500 companies reducing or scrapping their dividends in order to shore up their financials reached at 78, according to Ned Davis Research.

This time, it could be even worse. For April there have been 24 dividend suspensions or decreases in the S&P 500, according to Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. Outside of the S&P 500 that number is much higher, at 133 firms so far.

“In 2008 dividend cuts took place in stages, over a much longer time duration,” Silverblatt says. “This time it’s been so quick and sudden – and more cuts are coming.”

A second reason for caution is that a lofty dividend may be a sign of existential distress. If a company’s long-term prospects are dim, and the stock price is plummeting – perhaps it is in danger of being disrupted right out of existence – the yield will naturally shoot higher. Oil companies, for instance, are offering fat dividends right now – but how comfortable are you betting on fossil fuels?

In short, you need to be able to tell a hidden gem from fool’s gold. A few tips from the experts:

Don’t get seduced by yield alone

Dividend investors are typically buy-and-hold types, who want their stock to churn out steady income for decades to come. That in mind, you want sturdy companies with strong fundamentals. “Pick the company first, not the yield,” suggests Silverblatt. “Don’t go for high yield if you don’t believe in the company. You don’t want to have to check it every day to see if it’s still there.”

Some undervalued companies with a sustainable dividend, according to a recent research note from Chicago-based analysts Morningstar: Merck & Co., Dominion Energy, and Williams-Sonoma.

Research the payout ratio

Is a company’s dividend safe, or is it not? The so-called “payout ratio” will give you a clue. That’s the percentage of earnings that go towards funding the dividend, and if it’s sky-high, it could be a candidate to be cut back or eliminated.

For a frame of reference, the average S&P 500 payout ratio right now is 44%, and the long-term average is 57%. If a firm has a payout ratio of 80% or 90%, for example, be wary about that dividend’s long-term viability – especially since published ratios are based on the past quarter’s data. With the Covid-19 crisis, most payout ratios will be spiking higher going forward.

“A lower number gives companies more room for error,” says Clissold. “Don’t just screen for yield, but for company health factors like a strong balance sheet, the debt-to-equity ratio, and the payout ratio.”

Look for dividend growth

A healthy dividend is nice, but it doesn’t give you much of a sense about a company’s future prospects. A better clue: Dividend growth. If management teams have consistently boosted dividends over a long period of time, that indicates a positive trend-line that should give investors comfort.

The proof is in the pudding: Since the beginning of 1972, dividend-growing stocks have returned an average of 9.2% a year, according to Ned Davis Research. That compares to 6.9% a year for the S&P 500.

For true longevity, some income investors swear by the so-called “Dividend Aristocrats,” or companies which boosted their payouts for at least 25 years in a row.

Consider funds for extra safety

The dilemma for dividend lovers right now: While many companies are offering attractive yields, not all of them will make it through a prolonged economic crisis. The safer play is to buy a dividend-oriented fund, with a basket of hundreds of stocks to spread your risk more broadly. Top options, according to Morningstar: SPDR S&P Dividend ETF, T. Rowe Price Dividend Growth, Vanguard Dividend Growth, and Vanguard Dividend Appreciation.

“Income investors need to pick and stay with stocks not only based on their dividends, but on their ability to continue to pay,” says Silverblatt. “It’s no good to get a high-yielding stock, only to see the dividend cut – because then you’re stuck.”

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