Chasing the Highest Dividend Yields Poses a Risk to Investors

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In an era in which savings accounts pay less than 1 percent, conservative investors have found that the bank certificates of deposit, bonds and other fixed-income investments they used to rely on to provide portfolio income no longer get the job done.

With the Federal Reserve having cut interest rates to the bone, many dividend investors are gravitating to the highest-yielding dividend stocks they can find. And, surprisingly, you can still find stocks that yield 10 percent or more.

Real estate investment trusts like Annaly Capital (NLY) and American Capital Agency (AGNC) focus on mortgage-backed securities, using highly leveraged strategies to boost the amount of income they generate and then passing on the resulting income to shareholders through dividend distributions. Similarly, rural telecommunications company Windstream (WIN) has sustained a dividend payout of $1 per share for years, with its yield only recently falling below the 10-percent level by virtue of the stock having seen its price rise sharply.

The Perils of Hitting Pay Dirt

With such attractive payouts, it's understandable why high-yield dividend stocks are so popular. But investors also have to be careful with stocks that pay high yields, because often, those yield levels reflect a great deal of uncertainty about the company's prospects.

Annaly Capital and American Capital Agency, for instance, have both lost about a third of their share price since mid-2013, as investors anticipated that interest rates would start to rise and therefore that the value of the bonds that the two mortgage REITs owned would start to fall. Moreover, higher rates would increase financing costs for their leverage strategy, further hurting income levels and therefore making dividends harder to sustain.

Already, the two mortgage REITs have dramatically reduced their payouts on multiple occasions over the past few years. So far, Windstream has managed to avoid that fate, but other companies in the same industry that used to pay similarly high yields have had to make dividend cuts in recent years.

The Virtues of Dividend Growth Stocks

Instead of focusing on yield, many dividend investors instead look for consistent track records of growth in the amount that stocks pay in dividends. Well-known stocks including Coca-Cola (KO), 3M (MMM), and Procter & Gamble (PG) have yields in the 2 percent to 3.5 percent range, but they've raised their dividend payouts each and every year for more than a half century. Over time, that means that shareholders have received ever-increasing quarterly dividend checks that now represent a huge percentage of what they originally paid for the stock.

Even better, regular, reliable dividend increases show that a company can weather the ups and downs of the economy and still succeed in growing their overall business.

For example, Coca-Cola has seen some struggles of late as concerns about the health impacts of its carbonated beverages have weighed on sales in key markets. Yet Coca-Cola's deal to acquire a substantial stake in coffee-brewer maker Keurig Green Mountain (GMCR) shows the company's willingness to adapt and pursue more lucrative niches of the beverage market. Procter & Gamble and 3M have also overcome short-term obstacles in their growth trajectories but have kept earnings rising and pushed up their dividend payments accordingly.

The dependability of these stocks' dividends means that investors don't need to worry as much about the double-hit that many high-yield dividend stocks suffer. When a favorite stock of dividend investors has to cut its dividend, investors typically have to deal not only with a reduction in income but also with a plunge in the stock price, adding outright capital losses to the damage tally.

Finally, another reason to like dividend stocks is that as a group, they handily outperform their non-dividend-paying brethren on total return. (Our analysts have put together this free list of nine dividend stocks recommended for every income investor's portfolio.)

Be Smart With Dividends

As income investors struggle to get the cash flow they need from their investments, dividend stocks look more attractive than ever. But rather than maximizing current income, looking at safer dividend-growth companies can be the better path to long-term success in producing dependable income you can count on for years to come.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger. He has no position in any stocks mentioned. The Motley Fool recommends 3M, Coca-Cola, Keurig Green Mountain and Procter & Gamble. The Motley Fool has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola.