DIV 302Lesson 4 of 60 of 6
Yield Traps
A big yield that exists because the market already expects a cut.
What you’ll learn
- What a yield trap is and how one forms
- The warning signs that show up before most cuts
- A five question test you can run on any high yielder
- Why a cut usually costs you twice: less income and a lower price
A yield trap is a stock or fund with a tempting yield that exists mainly because the market expects trouble. It lures in income investors right before the dividend is cut and the price falls further. The trap isn’t the high yield itself. It’s buying the yield without asking why it’s high.
How a trap forms
- A company’s business weakens: falling sales, rising costs, too much debt.
- Investors notice and sell. The price drops.
- The dividend hasn’t changed yet, so the yield rises, often to the top of the screeners.
- Income investors see the high yield and buy.
- The company cuts the dividend. The price falls again as income holders leave.
Watch the numbers move in the widget. Start with a price that has fallen a long way and see what a cut does to the yield you were promised:
Why a cut costs you twice
The warning signs
| Sign | What to look for |
|---|---|
| Yield far above its own history | Today's yield well above its five-year average |
| Yield far above its peers | Double or more the yield of similar companies |
| Payout ratio above 100% | Especially from free cash flow, and especially for several years |
| Shrinking business | Falling revenue or profit margins for two or more years |
| Rising debt | Borrowing climbing while cash flow doesn't |
| Raises stalled | Long time raiser suddenly holding flat or giving token increases |
| Credit downgrades | Rating agencies cutting the company's debt rating |
| Management language | Repeated insistence that the dividend is safe while the numbers weaken |
No single sign proves a trap. Three or four together usually do. You saw how they lined up before real cuts in Dividend Cuts: Warning Signs and Real Examples.
The five question test
- Why is the yield high? If you can’t explain it, don’t buy it yet.
- Is the dividend covered by free cash flow?
- Is the business growing, flat or shrinking?
- Can the balance sheet survive a bad year without cutting?
- If the dividend were cut in half tomorrow, would you still want to own it?
That last question is the most revealing. If your only reason to own something is the yield, you’re exposed to exactly the event the market is worried about. Use the scorecard to put numbers on the first four:
Traps in funds
Funds can be traps too. A fund showing a 60% yield because its price has collapsed, or because its latest payment was unusually large, is the fund equivalent. For funds, the tell is total return far below the distribution rate, covered in Distribution Rate vs Total Return.
High yields to practice on
Here are some of the higher yielding stocks and funds in Dividend Duel’s data. This isn’t a list of traps: some of these are perfectly healthy. Use them to practice the five questions.
| Ticker | Name | Yield | 1Y total return | 5Y total return | 1Y price change |
|---|---|---|---|---|---|
| PSEC | Prospect Capital Corporation | 21.76% | -15.6% | -52.1% | -30.6% |
| AGNC | AGNC Investment Corp. | 16.65% | -1.5% | +8.3% | -14.0% |
| KBWD | Invesco KBW High Dividend Yield Financial ETF | 15.01% | -9.6% | -6.7% | -20.8% |
| ARCC | Ares Capital Corporation | 10.20% | +3.2% | +46.2% | -6.6% |
| MO | Altria | 6.54% | +10.3% | +116.4% | +3.3% |
| PFE | Pfizer | 6.28% | +7.2% | -15.5% | +0.1% |
| VZ | Verizon | 6.18% | +12.2% | +15.5% | +5.0% |
| EPD | Enterprise Products Partners L.P. | 6.09% | +23.8% | +127.2% | +16.2% |
| T | AT&T | 4.59% | -6.2% | +58.6% | -10.4% |
Check your understanding
4 questionsWhat is a yield trap?
A stock yielded 3% for years. After a 45% price drop it now yields 5.5%, and its payout ratio is 115%. What's the best reading?
You buy a $30 stock yielding 8%. The company halves its dividend and the price falls to $24. What happened to your income and your investment?
Which is NOT usually a yield trap warning sign?
Related lessons
This lesson is for education only and isn’t financial, investment or tax advice. Tickers are used as examples of how things work, not as recommendations. Figures marked as live come from Dividend Duel’s market data and change daily. See our disclosure.