(PUB) Investing 2016

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11 Morningstar FundInvestor January 2016
Equity funds with high dividend yields can be enticing
to income-seeking investors. But often the higher
the yields, the higher the risks, too. Yields that are well
above those of the overall market tend not to be as
stable. There are a number of reasons for this. First,
high yields can be an indication that a company is
in distress. Two or three decades ago, stocks yielding
more than 5% were common. But with the S& P
500 yielding only about 2% these days, any stock with
a yield greater than 7% is probably distressed and
likely to cut its dividend.
Second, high dividend payout ratios often accompany
high yields. The dividend payout ratio is the per-
centage of earnings a company distributes to share-
holders as dividends. The higher the payout ratio,
the greater risk that a company may need to cut its
dividend if earnings fall. Plus, companies with high
payout ratios tend to have below-average dividend
growth. On the other hand, companies with low
payout ratios tend to have much more stable dividends.
A low payout ratio also gives companies more
flexibility to raise dividends.
This is important because dividend growth plays a big
role in determining total income over the life of
an investment. As a general guideline, the higher a
company’s, and by extension a fund’s, yield, the
less quickly it will grow over time. Over the short run,
this initial yield matters more than dividend growth.
But as the time horizon grows, dividend growth has a
greater impact on the overall payout.
Finally, a more timely risk these days is funds with
both high average payout and high average debt/
capital ratios. A company that has both a high payout
ratio and high debt has little flexibility should its
earnings fall. In such cases, companies will cut their
dividends first since debt payments are mandatory.
This is already being seen in the energy sector, where
earnings are being squeezed by low oil and gas prices.
Keep in mind that should a severe recession come
along, almost all dividend-oriented funds will own com-
panies that cut their dividends. That was largely
unavoidable during the 2008 credit crisis. We explore
three funds at the other end of the spectrum below.
All three funds are Morningstar Medalists, so we think
the risks are worthwhile, but we do want to highlight
that there is risk with income.
Vanguard High Dividend Yield Index VHDYX
This fund tracks the FTSE High Dividend Yield Index.
Importantly, the index excludes income-oriented REITs
and master limited partnerships. But the portfolio still
has a high 57% median payout ratio. For perspective,
the S&P 500’s is just 35%. Plus, a number of its hold-
ings’ dividends are potentially distressed given that 32
of the fund’s 437 holdings have yields greater than
7%. Communications company Windstream Holdings
WIN takes the cake with a trailing 12-month yield
of 33.95%. Finally, the portfolio’s 43.8% average debt/
capital is greater than the S&P 500’s 40.1%, which
itself is higher than it was heading into the credit crisis.
American Century Equity Income TWEIX
This fund doesn’t offer a terribly attractive trade-off
between yield and payout ratio. Its 57% median
payout ratio is one of the group’s highest, yet its 2.14%
trailing 12-month yield isn’t that much greater than
the S&P 500’s. To be fair, the fund’s pre-expense yield,
which gives a measure of prospective yield, is
higher at 3.61%. Even so, investors could find funds
with comparable yields, but lower payout ratios.
Vanguard Equity-Income VEIPX
About one third of this fund’s portfolio is composed
of stocks in the FTSE High Dividend Yield Index, and the
rest of the portfolio uses that index as its benchmark.
So, it’s not surprising that the fund’s metrics look sim-
ilar to those of sibling Vanguard High Dividend Yield
Index. This fund’s payout ratio and average debt are a
little more attractive thanks to comanager Michael
Reckmeyer’s emphasis on healthy balance sheets and
companies with decent growth prospects. K
Contact Kevin McDevitt at
High Payout Ratios Come With Risk
Red Flags | Kevin McDevitt
What is Red Flags?
Red Flags is designed to alert
you to funds’ hidden risks. Such
risks can take many forms,
including asset bloat, the
departure of a solid manager, or
a focus on an overhyped asset
class. Not every fund featured
in Red Flags is a sell, and in fact,
some are good long-term
holdings. But investors should
be prepared for a potentially
bumpier ride in the near future.