With the Fed keeping interest rates at record low levels, chasing after high-dividend paying stocks has been a popular trade among retail investors in the last two years and will most likely be for the next two years. As I wrote in an article I co-authored for Barron's recently, this is a risky strategy, especially for investors using borrowed money to finance this trade. Trading Direct, for instance, lends investors who are willing to assume a heavy debt load at a variable rate of 1.25 percent.
This means that these investors can reap a gain of 2.59 percent by investing the money in a utility ETF like XLU, a 3.60 percent gain by investing in an individual utility company like Duke Energy (NYSE:DUK), and a 4.65 percent gain by investing in a tobacco company like Altria Group (NYSE:MO) while popular stocks like Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) pay no dividend.
On the surface, this game is like printing money and then some. Investors who have been playing this game for the last year think they have hit the jackpot: They have reaped from both the "spread," the difference between the dividend rates and the margin rate, and the appreciation in the price of these stocks that ranges anywhere between 14 percent and 26 percent, compared to 4 percent for the S&P 500.
Dividends and one-year gains for selective stocks:
One-year gain (%)*
*Includes dividends as of 12/31
On a closer examination, this is a high-risk game for several reasons. First, it pushes the price of these stocks way above their fair value, e.g., the price warranted by economic and business fundamentals. Utilities and tobacco are usually slow-growth industries - Southern Company's (NYSE:SO) revenue, for instance, grows at 3 percent but trades at a P/E of 18.5 compared to around 13 for the S&P 500. Second, as more and more investors chase after these companies, pushing their stock prices higher, the "spread" narrows, making them less appealing and the trade becomes crowded.
Two years ago, for instance, XLU's yield was close to 5 percent, while now it is well below 4 percent. Third, it leaves investors exposed to a sharp increase in interest rates that may hurt them in two ways: on the investment side, as utility stocks may take a big hit, and on the borrowing side, as borrowing rates may spike higher and margin calls come in.
The bottom line: If something is too good to be true, it likely isn't true. Chasing after high-dividend stocks is a risky game, especially when it is financed with borrowed money at adjustable rates.