Can a 6% Dividend Yield Really Last? Here’s What History Says

A 6% dividend yield sounds like an income investor's dream, but the same number that makes a stock look attractive can signal something far more troubling beneath the surface. Knowing the difference before you buy could save your portfolio from…

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As soon as anyone hears the words “6% yield,” it’s going to grab a lot of attention, and for the right reasons. This is a strong return for most investors who want to generate real income and growth from a portfolio over time. This number gets even more appealing when you look at the average S&P 500 yield right now, which is sitting around 1.05%, so the opportunity to generate four times more than what the S&P is doing is undoubtedly appealing.

The challenge with hearing this yield number is that you really need to make sure you are aware of what you are getting for the yield. There are red flags that investors should be aware of, and knowing them isn’t just something to think about in passing, but they might be vital pieces of information before you start putting money into an investment.

For the most part, calculating a dividend yield is pretty easy to do, as you only have to take the annual dividend and divide it by the share price. It’s pretty simple to calculate, but the reality is that a company can raise its dividend payout, something just about every investor loves to see. However, if the share price falls, it pushes the yield higher automatically without the company having to do anything.

There is another scenario, which is usually the one that 6% dividends originate from, and it’s something that you have to scrutinize a little bit more. If a stock drops, especially quickly, it’s because the market has already started pricing in something wrong beneath the surface. The rising yield is likely more a symptom of a problem, and it isn’t necessarily a reason to make a stock purchase.

The moment you start digging deeper into what dividend sustainability can look like, there is a better-than-good chance you’ll wind up with the same conclusion each time. Yields that sit above the broader market tend to get cut at a higher rate as yields move closer to what would be considered “normal” levels. To be fair, this isn’t a hard rule, but it does give us something to consider, as the companies that are paying out 6% or more of their share price are often doing it at the very edge of what their cash flow levels can actually support.

What tells the real story is the payout ratio, and a company that is paying out 90% of its earnings as dividends is often the same company that doesn’t have much of a cushion. All it takes is one bad quarter, one interest rate move, or one unexpected capital expense, and a dividend cut happens, and investors are furious. A company that is only paying out 50% of its earnings has far more room to absorb a bad quarter or capital expense without impacting its dividend. The yield alone won’t tell an investor anything about a situation they are actually looking at, which takes us to the second scenario.

The second potential situation is the one where most 6% yields do come from, and it’s the one worth considering the most. If a stock falls drastically, then it is most probably due to the market having started pricing in the troubles behind the scenes, which is what will cause an increase in the yield.

There will no doubt be questions about high yields and any skepticism around these numbers would be fair, but there are some exceptions that should make the doubters feel better. Some sectors, like REITs, for example, carry structurally higher yields, and it has nothing to do with the company being in any kind of trouble. Instead, these companies are required, by law, to distribute roughly 90% of their taxable income. In other words, not only is an elevated yield normal, it’s just how it works.

The same goes for Business Development Companies, which operate under the same kind of rules of needing to distribute taxable income. For their part, MLPs in energy infrastructure also have historically supported higher payouts through long-term contracted cash flow and not earnings that can swing in either direction based on the market.

It always needs to be said that strong businesses that operate in stable industries can also support higher yields. Take a utility company that has regulated revenue and decades of consistent cash generation, which might have a similar 6% yield number as an REIT or BDC, but everything underneath is different.