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Part of constructing a winning portfolio includes finding stocks that pay high dividends – but there are some components to that strategy that investors must learn now to be successful.
At a time when CDs, Treasuries and money market instruments are yielding next to nothing, scores of investors are pouring money into the highest-paying dividend stocks.
But, there's a problem…
Indeed, five years of zero interest rate polices (ZIRP) has created distortions, pushing income-hungry investors to take on some added risks in terms of quality and duration.
Many investors – lured by hefty payouts – fail to look at a stock's fundamentals.
For example, some yields are high because the stock's price has appreciatively fallen. If the slump is temporary, it could portend an appealing opportunity.
If the fall is due to slumping product sales or management problems, the price decline could continue – and the dividend could be on its way to being slashed.
Another source of high-yield portfolio happiness, real estate investment trusts (REITs), can offer yields as high as 15% — but these substantial payouts may not last.
When Stocks that Pay High Dividends Turn Cold
When, not if because we know it's coming eventually, the Federal Reserve starts to taper its quantitative easing program (created to keep interest rates low and goose the ailing housing market), residential mortgage REITS are likely to slash dividend payouts. Share prices of some will tumble.
You see, since interest rates have hovered near zero for more than half a decade, mortgage REITs have enjoyed borrowing at these historic low rates to buy mortgage backed securities (MBS). The sizable spreads between low rates and the MBS yields have allowed REITs to reap significant profits, which they have passed on to shareholders through hearty dividends.
Since the first mumblings of a Fed taper, REITs and their shareholders have felt the effects. Here are just three examples:
American Capital Agency (Nasdaq: AGNC), down 21.9% year-to-date, trimmed its dividend by 16% on June 18.
American Capital Mortgage Investment Trust (Nasdaq: MTGE) has fallen 15.8% since January, and it slashed its dividend 25% on June 18.
Annaly Capital Management Inc. (NYSE: NLY) off 16.5% since the start of the year, cut its dividend 11% on June 19.
In short, when the Fed makes a move, not all dividend stocks will be good buys.
"High dividend yield doesn't give you a place to hide in an environment that doesn't favor equities," Sharon Hill, head of equity quantitative research and analytics at Delaware Investments, told The Wall Street Journal.
How to Find Stocks that Pay High Dividends – and Are "Buys"
This means investors hunting for dividend stocks need to be selective.
Consider, what you may give up in yield, you'll more than make up in long-term growth – and peace of mind.
And stay nimble. Don't "set it and forget it" forever.
"Dividend strategies need to shift," Russ Koesterich, chief investment strategist at Blackrock, told The Journal. "Otherwise investors may find that instead of changing with the times, the times change them."
Here are five things to keep in mind before settling on certain dividend stocks: