One of the first things that dividend investors look for is high yields. The higher the yield, the more income that stock can produce.
That single assumption makes a stock with a 10% yield look more appealing than one that only provides 3%. In reality, yield is only one piece of the puzzle, and focusing too much on that number can lead to problems.
To be clear, high yields aren’t bad. Investors just need to understand why those yields can be hiding something else.
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Why high yields can be misleading
When a stock falls in value, the yield, which is calculated based on the share price, rises.
A struggling business with a falling stock price may appear more attractive to investors who are only looking at the yield.
But when the business isn’t in trouble, or is recovering, that could be a buying opportunity.
Collecting that 10% yield won’t matter if the stock drops another 15%. What does matter is the total return, which combines the income received with any gain or loss in the share price.
That’s one reason why chasing yields isn’t always the best idea. And there are plenty of examples of that in the market right now.
Telus offers a great dividend, with a caveat
Telus (TSX:T) is one of Canada’s big telecoms, providing increasingly essential subscription-based services. This creates a defensive moat for investors.
But telecoms are also incredibly expensive businesses to maintain. They require capital, and higher interest rates increased the cost of financing those investments.
That pressured Telus’s bottom line and raised concerns about its debt and dividend. As the stock dropped, its yield rose.
As of the time of writing, Telus offers a yield of 11.3%, which is one of the highest yields on the market. It also means that a $10,000 investment could generate upwards of $1,100 in annual income.
That dip doesn’t mean Telus is a bad investment. Its essential services, recurring revenue, and substantial yield still offer appeal.
Telus paused its dividend-growth program to focus on strengthening free cash flow and improving its financial position. The quarterly dividend is still paid, but investors should no longer expect regular dividend increases.
BCE shows that dividend records can change
Another example of chasing high yields is with another telecom, BCE (TSX:BCE).
Like Telus, BCE faced higher financing costs, significant capital requirements, and shifting investor expectations. But unlike Telus, BCE didn’t just pause its dividend growth.
BCE was long considered one of Canada’s dividend darlings. The telecom has paid out dividends for over a century. Until recently, it also boasted a decade of annual increases as part of that streak.
But as conditions deteriorated, the yield rose into double-digit territory.
As part of its efforts to improve its balance sheet, BCE cut costs, sold assets, reduced its workforce, suspended dividend growth, and eventually reduced the dividend itself.
The reduction lowered the amount of income shareholders receive. This means that investors who bought BCE for its former yield experienced weakness in the share price.
In fact, the stock has dropped over 50% in the past five-year period.
BCE may emerge as a financially stronger company, but the dividend reset shows that high yields alone won’t help when payouts and business priorities change.
As of the time of writing, BCE yields 5.8%.
This ETF exchanges growth for income
One final example is BMO Canadian High Dividend Covered Call ETF (TSX:ZWC). The ETF takes a different approach. ZWC holds a diversified portfolio of Canadian dividend-paying companies and offers a 5.7% yield.
The ETF generates income by writing covered call options against part of its portfolio. The premiums received from those options help support the fund’s monthly distributions.
That can make this covered call ETF appealing to investors who prioritize consistent cash flow.
The trade-off is that covered calls can limit the fund’s upside when the underlying stocks rise sharply.
Look beyond the headline yield
High yields are attractive. But before buying a high-yield investment, investors need to look beyond the yield.
That includes determining whether the dividend is sustainable or whether the yield has been inflated by weakness in the stock.
TELUS, BCE, and ZWC can all have a place in an income-focused portfolio. But they should be a small part in a much larger, well-diversified portfolio.
