How to avoid the dividend stock 'yield trap'

Dividend stocks are a shiny new ornament for many financial advisors, especially those with older clients worried about maintaining income and spending power in uncertain economic times. But the shares aren't always a glistening addition to a retirement portfolio, and their tax rules can create costly traps.

The stocks pay out cash distributions quarterly or annually from a company's earnings, locking in some profit regardless of how they perform. Reinvesting the distributions, rather than cashing the check in the mail, sets a portfolio up for greater compounding of wealth down the line — what Fidelity Investments calls a "safety net of stock investing." It's a mindset that makes particular sense to older investors concerned about the power of a volatile Wall Street and rising consumer prices to deplete their nest eggs more quickly than expected.

Rob D. Kantor, the chief investment officer and co-founder of XML Financial Group, indicated that rather than asking whether dividend stocks should be in a diversified portfolio, advisors should now be asking which kind. Those with the highest yield, reflected as the percentage of share price paid out as a distribution, would seem to be the most attractive to own longer term. Yet stocks with the highest dividend yields have historically underperformed those that either don't pay dividends or have lower yields during periods of rising interest rates. As both Hartford Funds and Morningstar noted earlier this year, companies that made big payouts in one or more years often don't in subsequent years. 

"Money is made in all different ways," Kantor said. "Stocks that pay good dividends and continually increase their dividends over time become great income and growth portfolios."

Why now?
In recent years, growth stocks, or shares in companies expected to increase their revenues and earnings faster than normal, have overshadowed both value stocks, or shares trading at relatively low prices, and dividend-focused companies.

The majority of stocks in the S&P 500 index of large companies pay a dividend, as do most exchange-traded funds and many mutual funds. For nearly five decades, companies that increased or began paying a dividend have had the best-performing shares compared with those that didn't, according to Hartford Funds. So if dividend stocks are commonplace and the some companies that pay them do well — Hartford's finding averages companies with varying performance metrics — what's the special appeal now?

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Credit persistent inflation, rising interest rates and the end of the stock market's bull run. Financial data website YCharts shows that after declining steadily starting in March 2020, when the pandemic hit, yields began ticking up this year and now average 1.69%. The average dividend yield is historically 4.28%, according to DQYDJ, a financial website that cited S&P data.

Companies that pay cash dividends despite headwinds can be seen as on more solid footing and "safer." But because higher interest rates raise the cost of borrowing and meeting interest-related expenses, companies that pay higher dividends can prompt investors to chase "dividend yield."

The lure can be dangerous, according to dividend.com, a financial services website. "A dividend value trap occurs when a very high dividend yield attracts investors to a potentially troubled company," it says. 

While not all companies with a high dividend yield are problematic, "investors should question why a company is willing to pay out so much more than its peers," the website said. Hartford Funds found that companies in the second quartile of paying the highest dividend yields were the most likely to outperform the S&P 500 from 1930-2021.

Joseph Zappia, a principal and co-chief investment officer of LVW Advisors in Pittsford, New York, agreed that it is a mistake to lump all dividend stocks together. 

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Is a company paying a high-yield dividend because its stock price is low due to weakening fundamentals in its business? he asked. If so, he added, it can be a yield trap and the dividend could be cut or eliminated in the future.

Or does a company have have slower revenue and earnings growth? In that case, Zappia said that "most, if not all of, what you make on the stock could be the dividend" — AT&T and Verizon's high yields, but lousy stock performance, in recent years are an example.

Companies that pay out distributions instead of using the cash to reinvest in their operations are another red flag, as are those that aren't growing but pay dividends nonetheless because investors expect them to, shoring up their stock prices.

"In the end are you better off with that higher yield?" Zappia asked. "Probably not."

Dividends on the brain
The merits of dividend stocks have been drilled into the popular psyche in part due to prominent investors, according to a recent paper from the National Bureau of Economic Research. For example, Peter Lynch, whose deft management of Fidelity's Magellan Fund in the late 1970s and 1980s made him a household name, argued in his 1989 bestseller "One Up on Wall Street" that "the presence of the dividend can keep the stock price from falling as far" because "if investors are sure that the high [dividend] yield will hold up, they'll buy the stock just for that." 

Economist Burton Malkiel recommended in his 2019 book "A Random Walk Down Wall Street" that low interest rates at the time made holding dividend-paying stocks a smarter move than owning bonds.

The recommendations resonated more than the so-called "dividend irrelevance theorem," a 1961 formulation by two economists who said that whether or not a company pays a dividend has no impact on its stock price or ability to raise capital and that investors should ignore it, an NBER paper found.

Tax rules
As far as taxes on dividends are concerned, special rules apply. 

Rates for distributions range from 0% for low-income earners to 23.8%, the same as the preferential long-term capital gains rate, including the 3.8% Affordable Care Act levy, that applies to profits taken on assets held for at least a year. 

To get the preferential rate, an investor must hold a dividend-paying stock or fund for at least 61 days of a 121-day period that starts 60 days before the security makes a payout. If you don't meet that timeline, you owe ordinary rates — now a top 37% — on the payout. If a dividend stock or fund is held in a tax-deferred account such as an individual retirement plan or 401(k), it's not taxed until withdrawn, and at ordinary rates.