Skip to Content
Fund Spy

High Payout Ratios Come With Risk

Make sure you know how a fund achieves its high yield.

A version of this article was published in the January 2016 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Equity funds with high dividend yields can be enticing to income-seeking investors. But often the higher the yields, the higher the risks, too. Yields that are well above those of the overall market tend not to be as stable. There are a number of reasons for this. First, high yields can be an indication that a company is in distress. Two or three decades ago, stocks yielding more than 5% were common. But with the S&P 500 yielding only about 2% these days, any stock with a yield greater than 7% is probably distressed and likely to cut its dividend.

Second, high dividend payout ratios often accompany high yields. The dividend payout ratio is the percentage of earnings a company distributes to shareholders as dividends. The higher the payout ratio, the greater risk that a company may need to cut its dividend if earnings fall. Plus, companies with high payout ratios tend to have below-average dividend growth. On the other hand, companies with low payout ratios tend to have much more stable dividends. A low payout ratio also gives companies more flexibility to raise dividends.

This is important because dividend growth plays a big role in determining total income over the life of an investment. As a general guideline, the higher a company's, and by extension a fund's, yield, the less quickly it will grow over time. Over the short run, this initial yield matters more than dividend growth. But as the time horizon grows, dividend growth has a greater impact on the overall payout.

Finally, a more timely risk these days is funds with both high average payout and high average debt/capital ratios. A company that has both a high payout ratio and high debt has little flexibility should its earnings fall. In such cases, companies will cut their dividends first since debt payments are mandatory. This has been seen in the energy sector, where earnings are being squeezed by low oil and gas prices.

Keep in mind that should a severe recession come along, almost all dividend-oriented funds will own companies that cut their dividends. That was largely unavoidable during the 2008 credit crisis. Below, we explore three funds at the other end of the spectrum. All three funds are Morningstar Medalists, so we think the risks are worthwhile, but we do want to highlight that there is risk with income.

 Vanguard High Dividend Yield Index (VHDYX)
This fund tracks the FTSE High Dividend Yield Index. Importantly, the index excludes income-oriented REITs and master limited partnerships. But the portfolio still has a high 59% median payout ratio. For perspective, the S&P 500's is just 35%. Plus, a number of its holdings' dividends are potentially distressed given that 34 of the fund's 431 holdings have yields greater than 7%. Drilling company Ocean Rig (ORIG) takes the cake with a trailing 12-month yield of 36.2%. Finally, the portfolio's 45.0% average debt/capital is greater than the S&P 500's 41.3%, which itself is higher than it was heading into the credit crisis.

 American Century Equity Income (TWEIX)
This fund doesn't offer a terribly attractive trade-off between yield and payout ratio. Its 54% median payout ratio is one of the group's highest, yet its 2.35% trailing 12-month yield isn't that much greater than the S&P 500's. To be fair, the fund's pre-expense yield, which gives a measure of prospective yield, is higher at 3.30%. Even so, investors could find funds with comparable yields but lower payout ratios.

 Vanguard Equity-Income (VEIPX)  
About one third of this fund's portfolio is composed of stocks in the FTSE High Dividend Yield Index, and the rest of the portfolio uses that index as its benchmark. So, it's not surprising that the fund's metrics look similar to those of sibling Vanguard High Dividend Yield Index. This fund's latest payout ratio and average debt are a little more attractive--at 54.0% and 42.8%, respectively--thanks to comanager Michael Reckmeyer's emphasis on healthy balance sheets and companies with decent growth prospects.

Kevin McDevitt does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.