Beware of Juicy Dividends

| About: BANK AMER (BAC.PL)

Income oriented investors are yield-starved with T-bills yielding nearly zero. For those of you willing to extend the maturity of your Treasury investments, you can get nearly 1.5% on five-year securities or about 2.4% if you can commit to a 10-year investment.

Given the paltry payouts from Treasury bills and notes, it’s no wonder that investors are being enticed by big fat juicy dividends from stocks and bonds of questionable quality. The yield from stocks is higher than bonds for the first time since 1958 and is nearly twice as high as it was a year ago. However, before you get too excited, think about how this came about. Stocks did not raise their dividends. On the contrary, the prices of many dividend-paying stocks were cut in half over the past year. This has the effect of doubling the dividend yield without increasing the actual dollar amount paid out.

Investors also need to be aware that many quote sources report dividend yields based on the payouts of the preceding 12 months divided by the current price. Even if a company were to announce a significant dividend cut today, the yield calculation is often based on the former payout, not what is going to paid in the next 12 months.

Most importantly, dividends are not sacred. DIVIDENDS CAN AND WILL BE CUT.

Bank of America (NYSE:BAC) is an interesting and perhaps extreme example, but it illustrates many of my points. A little more than three months ago, BAC was paying quarterly dividends of $0.64, which provided the stock with a nice 7.3% yield (as of 9/30/08). Many investors were enticed into buying this seemingly juicy yield. Two months later, at the end of November, the yield on BAC had climbed to the lofty level of 16.2%. This was not the result of BAC increasing the dividend amount, it was because the stock price dropped nearly 53%.

Three days later, BAC cut the dividend in half to $0.32, bringing the forward-looking yield back to a slightly more realistic high single-digit level. After getting their investment cut in half, investors now had to deal with a 50% reduction in the dividend stream also.

Last Thursday (1/15/09), the anticipated dividend yield on BAC was again a big fat juicy 9%. The following day, BAC slashed the dividend by more than 97% to a quarterly payout of just one penny per share. Yesterday, BAC closed at $5.10, representing an additional 50% loss of value the past three market days.

Dividend proponents like to say that dividends protect the share price and allow you to be “paid to wait” for a share price recovery. That is not always the case. Sometimes high dividends are a warning. Dividends are not guaranteed.

Today, many quote systems are saying the dividend yield on BAC is 25%. However, based on the next four one-penny payouts, the actual yield is less 1%. But if the price keeps dropping, the yield may soon be juicy once again.

Disclosure: No positions in BAC