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Income investors cautioned to beware of yield trap

Dr Don Hamson
— 1 minute read

With official cash rates and bond yields plumbing record lows coupled with equity markets at record highs, investors of all types are increasingly looking for dividend payments as a replacement for regular income from term deposits and/or bonds.

Don Hamson

This is a big change from a decade ago, when term deposits were generally producing higher returns than dividend income. 

As the focus on dividend income increases, investors need to be more aware of potential dividend traps. 

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This is where yields appear to increase, but this can be the result of where the underlying share price weakens. 

Accordingly, investors should not blindly invest in the highest yielding stocks. 

Consider how the share prices of some dividend-paying stocks have performed over the past 12 months to 18 months.  If the reason a stock is trading on a high yield is because its share price has collapsed, this is usually not a good sign, and could signal the stock is a dividend trap. It could be a stock that trades on high historic yields, but could subsequently cuts its dividends.

Investors should instead focus on stocks that provide both consistent dividend payouts and underlying capital growth, rather than one or the other.

Avoiding yield traps is key to income investing today and why investors need to be more active in their approach.

It is timely for retirees, in particular, to reconsider their income-generating asset mix. While the recent Reserve Bank of Australia rate cuts were beneficial to home owners and people trying to buy a home, rate cuts also see Australian retirees receive less income from their floating rate income investment assets. Many income-related products, like income securities or bank hybrids are priced at a margin to bank bill rates, and have seen their income fall.

Retirees living off cash-linked income will struggle to make ends meet following the recent rate cuts. So, it is timely for retirees to reconsider their income-generating asset mix and which dividend stocks they invest in.  

At a time when interest rates are hitting record lows in Australia, dividends paid by Australian companies have never been stronger. Thankfully, given the recent election result, retirees can continue to bank on receiving franking credits from Australian share investments.

Dr Don Hamson, founder and managing director, Plato Investment Management

 

Income investors cautioned to beware of yield trap
Don Hamson
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