3 Stocks That Are Nothing but Dividend Yield Traps

By Markets Fool.com

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Source: Flickr user George Thomas.

When it comes to investing in high-paying dividend stocks, there's a fine line between what's safe and what's not. Some high-dividend stocks are completely safe, such as many property-owning REITS that legally must pay out 90% of their income.

On the other hand, some stocks' dividends seem too good to be true -- because they are. Here are three high-dividend stocks that could fall into this category.

Dan Caplinger
One industry I'm particularly concerned about right now is the offshore drilling sector, because the plunge in oil prices has made drilling in hard-to-reach areas of the world much less economically viable. Noble Corp. has thus far avoided the dividend cuts that some of its peers have enacted, and it currently sports a yield of 8.1%. But it remains to be seen whether the company will sustain that payout, particularly as the dividend has more than tripled just since mid-2013.

For now, Noble can afford to continue paying its $1.50 per-share annual dividend, as the company earned $2.18 per share from continuing operations in 2014. In its most recent earnings report, Noble pointed out how rapid declines in oil prices put pressure on the company. Yet Noble believes that by retiring older rigs in favor of newly built drillships and jackups, it can take advantage of the next cyclical upturn. Still, competitor Seadrill has already suspended its dividend, and there's no guarantee Noble will avoid the same fate. With investors expecting only $1.34 per share in earnings for 2016, Noble shareholders might run out of time before oil prices fully recover.

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Matt Frankel
One possible dividend trap is American Capital Agency , or any highly leveraged mortgage REIT, for that matter. If interest rates begin to rise this year, the company's profits could erode quickly.

Basically, these companies make money by borrowing money at low short-term interest rates and using the money to buy mortgage-backed securities. The profit is the difference between the two rates. For example, if the company can borrow money at 2% interest and earn 4% on its investments, the 2% "spread" is its profit.

In order to provide the double-digit yields investors want, these companies borrow money at very high leverage ratios. American Capital Agency has a 4.8-to-one leverage ratio. In other words, for every dollar in equity the company has, it's borrowing $4.80 to finance its investments.

If interest rates rise, the company must borrow at a higher short-term rate, but its investments still pay the same interest. The spread between the rates narrows, and so does the company's profit. Because of the high leverage, a small increase in rates can cause a huge drop in profitability. In fact, a sufficiently large rate spike can eliminate the profit margin.

Of course, this is a simplified explanation, and American Capital Agency is somewhat hedged to lessen the blow of a rate increase. However, the general principle applies, so be cautious about mortgage REITs if rates creep upward.

Jordan Wathen
Fifth Street Finance stands out to me as nothing more than a yield trap. The asset manager lowered its dividend at the beginning of 2014, only to inexplicably raise the payout last summer. The share price popped as a result, and Fifth Street Finance grew its balance sheet by issuing new shares.

At the start of 2015, Fifth Street Finance has lowered its dividend from $0.09 per share per month to $0.06 per share, even going so far as not to pay a dividend in February. These dividend increases and decreases show, to me, Fifth Street Finance's lack of concern for its shareholder base. After all, it is one of the least-efficient companies in its industry, sending some 30% of total investment income (essentially revenue) to its managers. As earnings for its shareholders have gone down, payments to its managers have only gone up.

This is just another classic case of a company that is run for the benefit of its operators, rather than its investors. Its managers, who have little skin in the game, are all too happy to collect hedge-fund-like 2-and-20 fees on its assets despite their record of poor performance. That conflict and imbalance of interests make Fifth Street Finance a dividend stock I'd avoid, no matter how cheap.

The article 3 Stocks That Are Nothing but Dividend Yield Traps originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.