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Danger Lurks for These 3 Dividend Stocks

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Dan Caplinger, The Motley Fool
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If you want your portfolio to generate income even as you hold onto lucrative growth opportunities, then dividend stocks can be just what you're looking for. Not only do these stocks make regular income payments to their shareholders, but they also often have healthy businesses with strategic vision to help them keep expanding in their industries.

Sometimes, though, you can have too much of a good thing. Dividend stocks with top dividend yields come with special risks, and although that doesn't guarantee that you'll get burned, the chances of a setback are greater. Below, I'll look at BP Prudhoe Bay Royalty Trust (NYSE: BPT), CenturyLink (NYSE: CTL), and Annaly Capital Management (NYSE: NLY) to explain why their yields are so high and what dangers could lurk beneath the surface.

Industry symbols and the word "Dividends" on a blue background of squares.
Industry symbols and the word "Dividends" on a blue background of squares.

Image source: Getty Images.

Banking on energy

It's hard to find a higher yield than BP Prudhoe Bay Royalty Trust. When you look at Yahoo! Finance, you'll see a dividend yield of more than 20%. However, there's some background you need to know in order to understand what this payout really means for investors.

As its name indicates, BP Prudhoe Bay is a royalty trust, and the distributions that it makes are based on the production from its assets as well as the prevailing market prices at which the royalty trust is able to sell those products. The $5.06 per share in dividends represents the total of what BP Prudhoe Bay has paid out over the past 12 months, but the most recent payout of just over $1 per share suggests a more modest yield of around 16%.

More importantly, royalty trusts in general have characteristics that are different from those of most other companies. Often, a royalty trust is set up so that when production rates fall below certain levels, the trust gets liquidated, with any assets sold and any proceeds distributed to shareholders. When liquidation happens, what investors get can be far less than what they paid for their shares. In other words, when you look at a 20% yield, what you might actually be getting is a portion of your investment principal back -- because when the trust comes to an end, there might not be anything of value left to represent a return of your capital investment. If oil prices stay strong and BP Prudhoe Bay remains able to produce crude, then it could still thrive. But you need to be aware of the risks if the energy market performs poorly.

Moving forward with a big dividend cut

CenturyLink has been near the top of the dividend yield spectrum for a long time, but dividend investors have gotten burned before, and it just happened again. When the telecom company reported its fourth-quarter financial results, it also said that it had decided to make a 54% dividend cut, reducing its annual per-share payout from $2.16 to $1. That still puts CenturyLink's yield at a good-looking 7%, but obviously that's a far cry from the nearly 15% payout shareholders had hoped to keep getting indefinitely.

CenturyLink has a lot of debt on its balance sheet, and the move on the dividend was designed to free up capital for investment in growth initiatives as well as reducing the company's leverage ratio. Yet it's far from certain whether CenturyLink's latest moves will be sufficient to get the job done -- and as we've seen from some of the company's telecom peers, it's definitely possible that further dividend cuts will be needed before CenturyLink gets its finances in order.

Beware of yield curve moves

Finally, Annaly Capital's 11.5% dividend yield is nothing new, with the mortgage-oriented real estate investment trust having sported double-digit percentage yields frequently in recent years. The REIT makes money by borrowing through short-term credit facilities and then buying mortgage-backed securities with the loan proceeds, on which it expects to get larger amounts of interest income. The difference goes to fund the dividend.

The risk that Annaly faces is that there's no guarantee that the securities it purchases for investment won't drop in value, especially if long-term interest rates rise. In addition, if short-term rates go up, then Annaly's borrowing costs can go up, jeopardizing the profit it makes on its investments. When that's happened in the past, the mortgage REIT has sometimes had to cut its dividend -- and while that hasn't happened yet during this particular cycle, the current dividend payment is just half the size of what Annaly paid when conditions were more favorable in the early 2010s.

Be smart about dividend investing

Not all dividend stocks are unsafe, but those with high yields have less margin for error. If you're going to invest in stocks like Annaly, CenturyLink, and BP Prudhoe Bay, you have to have your eyes wide open -- and be ready for whatever the market can throw your way.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.