It looks unlikely that the Bank of England is going to raise interest rates anytime soon. The bond markets are currently pricing in a small 0.15% rate hike next summer. Even that will only take us to a base rate of 0.25%. For me, this means that I need to make my money work harder, as I’m not going to get any interest from holding funds in cash. High-dividend-yield stocks are alternatives that I can look at instead.
Making income from shares
The concept of a high-dividend-yield stock comes in two parts. First comes the dividend yield itself. This is a calculation I can work out from a stock that pays out a regular dividend to shareholders. By comparing the share price to the dividend per share, I can get a annual percentage return figure. Although it’s not exactly the same as an interest rate on a cash account (and certainly isn’t guaranteed), it does have some similarities.
The second part relates to having a high-dividend-yield. This is usually added on for a stock that has a yield above the FTSE 100 average. This currently sits around 3.3%. However, there are some stocks that offer yields at much higher levels. Currently, Evraz has the highest yield in the index, at 12.95%.
The risks of high-dividend-yield stocks
As a general rule of thumb, high-dividend-yield stocks usually carry more risk than others. After all, the share price could fall. Dividend payments could be cut in the future. So logically, I need to be compensated with a higher yield than other assets offer. Yet this added compensation (think of it as a risk premium) needs to be reasonable when I compare it to returns from the bond or cash equivalents.
But with a yield of 10%+, usually a siren sounds in my head to stay away. It could be high because the share price has been falling, with the company in trouble. This pumps the yield higher in the short run, but ultimately could see the dividend per share cut at the next results presentation.
To help me manage my risk, I’d go for a slightly lower overall yield, but still well above average. There are several stocks that fit into the bucket around the 7% or 8% level that I think have sustainable yields. These still comfortably allow me to generate a high level of passive income relative to other assets.
Passive income from a mix of stocks
I’d look to invest in both FTSE 100 and FTSE 250 stocks with generous yields. Ideally I’d choose between half a dozen to a dozen stocks to diversify my portfolio. This does depend on how much I’m prepared to invest. The smaller the amount, the more transaction fees will eat into my pot, so I’d be inclined to choose fewer stocks to minimise this.
To achieve my passive income goals, selecting a range of stocks also helps as the dividends get paid at different points during the year. If I hold enough stocks, it’s likely I’ll receive some income each month.
So although I need to be careful with high-dividend-yield stocks, good rewards can be had from investing here.