Right now, there are a number of shares in the FTSE 100 index that have gigantic dividend yields. Some examples include housebuilder Persimmon (11.4%), mining company Rio Tinto (12.7%), Tobacco group Imperial Brands (8.6%), and housebuilder Barratt Developments (8.8%).
Should I buy these shares for passive income? Let’s discuss.
A high dividend yield can be a trap
I can see why UK investors might be attracted to these dividend shares. In today’s low interest rate environment, those monster yields look mighty tempting.
However, I have some concerns over these high yields. Because if there’s one thing I’ve learnt as a long-term dividend investor, it’s that if a yield looks too good to be true, it often is.
You see, unlike interest on a savings account, dividends are never guaranteed. Companies can cut their dividend payouts at any time. And here’s the thing. A very high yield is often a warning sign that a dividend cut is on the way.
More often than not, if a company has an extremely high yield, it’s because the ‘smart money’ (large institutions) has already dumped the stock, believing the company is in trouble and the dividend isn’t sustainable. This pushes the share price down and the yield up.
The smart money doesn’t always get it right, of course. But it often does. In the last few years, there have been many high-yielding FTSE 100 companies that have cut their dividends. Examples include Shell, Vodafone, and WPP.
If a company does cut its dividend, it can be pretty ugly for investors. Not only do shareholders face lower dividend payments, but they also tend to face capital losses as well.
Are these FTSE 100 dividend payouts sustainable?
As for the FTSE 100 companies I mentioned above, I wouldn’t be all that surprised to see dividend cuts in the near future. Housebuilders, such as Persimmon and Barratt Developments, are highly cyclical and tend to struggle during economic downturns. With the UK potentially facing a recession in the not-too-distant future due to the energy crisis, their dividends may not be sustainable.
Meanwhile, Imperial Brands has been struggling for growth for years now and is going to have to spend a lot of money to reinvent itself in today’s more health-conscious world. It cut its dividend not so long ago and could cut it again to conserve cash.
As for Rio, it’s a boom-and-bust cyclical company. It’s paying out big dividends right now due the fact commodity prices are sky-high. This isn’t likely to last forever though.
How I invest in dividend shares today
Given the risks involved in investing in high-yield dividend shares, I won’t be investing in the FTSE 100 high yielders.
Instead, I’ll be focusing on lower yielding companies that have the potential to consistently lift their dividend payments over time. An example here is alcoholic beverages company Diageo, which has now registered over 20 consecutive annual dividend increases.
I’ve found that these kinds of companies tend to deliver the best returns for investors over the long run (there’s no guarantee of good performance, of course). Because as their dividend payments rise over time, their share prices generally do too.