Don't Let This High-Yield Dividend Trap Snare You

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Oil Declines Below 60USD A Barrel
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Investors who need income from their investment portfolios have come to appreciate dividend stocks over the past several years, as they've provided a viable alternative to fixed-income investments like bonds and bank CDs. Even when prevailing interest rates have been low, dividend stocks have carried attractive yields and in many cases have supplemented their income with rises in their share prices as well.

Recently, though, the yields on certain dividend stocks have become almost too good to be true. Many of those stocks will end up disappointing new investors, as yields based on backward-looking financial figures will prove to be unsustainable under the rapidly changing conditions that these companies face in their respective industries right now. Let's take a look at some of these potential danger areas in the dividend-stock market to make sure you don't end up getting tricked.

Offshore Drilling Profits: Going Up in Smoke?

The recent decline in energy prices has gotten a lot of attention among investors and the general public alike, with consumers celebrating falling prices at the pump while energy-stock investors feel the pain from the drop in crude oil. One of the hardest-hit areas of the stock market has been the offshore drilling sector, which had thrived in recent years from heavy levels of drilling activity due to high oil prices.

As an example, Seadrill (SDRL) has specialized in providing state-of-the-art drillships for deepwater operations, and until very recently, the company could get customers to pay roughly $600,000 per day on contracts to use those drillships for deepwater ocean exploration. Even during the third quarter of this year, Seadrill managed to get Brazil's Petrobras (PBR) to spend $500,000 per day for contracts on four of its rigs. Yet after the oil-price decline, Seadrill expects drilling activity to slow markedly, and as a result, it suspended its dividend payment late last month in order to reduce its debt and give itself more flexibility to pursue strategic opportunities. Some financial services continue to point to Seadrill's past $4-per-share yearly dividend and its consequent 35 percent dividend yield, but investors won't see a penny in dividends until Seadrill decides it has gotten past its current challenges.

Other drilling companies haven't yet cut their dividends but are expected to do so shortly. Transocean (RIG), for instance, is in much the same boat as Seadrill, except that its fleet of rigs relies more on older equipment than Seadrill does. Its trailing dividend yield is 17 percent, but the same poor industry conditions that have hurt Seadrill will also affect Transocean's results, and investors should therefore watch out for falling dividends from Transocean and throughout the drilling sector.

Royalty Trusts: Watch Out for Falling Cash Flow

Royalty trusts are another part of the energy market that's sensitive to price fluctuations. These entities earn income and pay out dividends based on the market price of the oil and natural gas that they produce and sell. Falling prices for crude oil have a direct impact on how much money these royalty trusts bring in, and that in turn jeopardizes dividend payments for investors.

For instance, BP Prudhoe Bay Royalty Trust (BPT) pays dividends based on production at BP's (BP) Alaskan operations. The trust has paid out more than $10.50 per share in dividend distributions over the past 12 months, giving it a dividend yield of more than 17 percent. Already, though, trust shareholders have seen a negative impact from falling oil prices, as the trust said in its third-quarter announcement that lower prices were in part responsible for a decline in its dividend both from the previous quarter and from year-earlier levels. With average oil prices in the fourth quarter having fallen sharply from the roughly $90 per barrel that many producers realized in the third quarter, BP Prudhoe Bay is likely to see its implied forward dividend yield drop considerably.

BP Prudhoe Bay isn't the only royalty trust that's vulnerable to dividend declines. San Juan Basin Royalty Trust (SJT) pays monthly distributions, and they've already fallen more than 40 percent from their highest levels of the year back in May. Yet again, some financial news sources report yields that don't reflect the declines in dividend payments, instead basing their figures on now-out-of-date numbers that are based on oil at much higher prices.

Stay Smart About Dividends

Smart dividend investors always look for great payouts from stocks, and sometimes, you can get incredible deals by looking at the highest-yielding stocks in the market. Often, though, high yields come with high risk -- and it's important not to find yourself in a trap simply because you didn't do your homework up front.

Motley Fool contributor Dan Caplinger loves stocks that pay him money. You can follow him on Twitter @DanCaplinger or on Google+. The Motley Fool recommends Seadrill, and owns shares of Seadrill and Transocean. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.
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