When Does High Yield On Bonds Mean Distressed?

investment graphs on an ipad

 

Yields on bonds have fallen in recent years and have remained low for some time. Income-seeking investors have started searching for income-producing alternatives. This trend has influenced many investors to take on riskier investments to replace today’s disappointing bond market yields. One of those alternatives is high-yielding dividend paying stocks.

What are yields on bonds?

“A bond yield is the amount of return an investor realizes on a bond. Several types of bond yields exist, including nominal yield which is the interest paid divided by the face value of the bond, and current yield which equals annual earnings of the bond divided by its current market price. Additionally, required yield refers to the amount of yield a bond issuer must offer to attract investors.” According to Investopedia.

To dive into this further, let’s examine a real company that fits this profile. We’ll call it “Company A.”

With a current yield of 4%, it appears attractive in today’s market. An income-hungry investor notes that the yield has increased over the last four years. Let’s explore what this means, but first take a look at dividend yields.

How is a dividend yield calculated?

Dividend yield is calculated using the per-share annual dividend and the stock price of a company. Therefore, a stock’s “yield” is heavily dependent on both these factors, and both must be considered when evaluating the investment opportunity.

Below is a chart showing Company A’s stock price compared to its dividend yield from 2007 – 2014.

line graph showing Company A’s stock price compared to its dividend yield from 2007 - 2014

We see that the price of the stock and the dividend yield move conversely. The recent increase in yield may have been caused by the dramatic decline in the price of the stock. This chart demonstrates how the yield only tells part of the story.

The rest of the story unfolds when we look at the growth of dividend per share:

line graph showing growth of dividend per share from 2007 to 2014

In the above chart, we see the historical growth of Company A’s dividends. Between 2007 and 2011, the payout increased from 12.5 cents to 17.5 cents per share. This company did not cut the dividend during the sharp price decline in 2011, which may indicate that the company expects to be able to endure the downturn.

The chart also shows that, since 2012, both the dividend and the stock price have remained stagnant.  This stagnation and the weakness of the stock price should cause an investor to dig deeper into the financial strength of the company before investing. A review of the financial statements should provide information about whether the company can afford to continue the dividend payout and if corporate performance is on the right track.

Conclusion

When screening for high yield, don’t stop at yield; strive to understand why it’s high!

Reaching for yield in dividend-paying stocks can be an enticing alternative for income. However, a dramatic decrease in a stock’s price may result in an inflated yield and misrepresentation of a good investment. Further analysis to determine if the company’s cash flow is under pressure or distressed may make a difference in the investment decision. Taking the time to evaluate these factors is worthwhile before deciding whether to place a trade.

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