Can a 6% Dividend Yield Really Last? Here’s What History Says

As soon as anyone hears the words “6% yield,” it’s going to grab a lot of attention, and for the right reasons. This is a strong return for most investors who want to generate real income and growth from a portfolio over time. This number gets even more appealing when you look at the average S&P 500 yield right now, which is sitting around 1.05%, so the opportunity to generate four times more than what the S&P is doing is undoubtedly appealing.

The challenge with hearing this yield number is that you really need to make sure you are aware of what you are getting for the yield. There are red flags that investors should be aware of, and knowing them isn’t just something to think about in passing, but they might be vital pieces of information before you start putting money into an investment.

Why High Yields Appear in the First Place

For the most part, calculating a dividend yield is pretty easy to do, as you only have to take the annual dividend and divide it by the share price. It’s pretty simple to calculate, but the reality is that a company can raise its dividend payout, something just about every investor loves to see. However, if the share price falls, it pushes the yield higher automatically without the company having to do anything.

There is another scenario, which is usually the one that 6% dividends originate from, and it’s something that you have to scrutinize a little bit more. If a stock drops, especially quickly, it’s because the market has already started pricing in something wrong beneath the surface. The rising yield is likely more a symptom of a problem, and it isn’t necessarily a reason to make a stock purchase.

What the Historical Record Shows

The moment you start digging deeper into what dividend sustainability can look like, there is a better-than-good chance you’ll wind up with the same conclusion each time. Yields that sit above the broader market tend to get cut at a higher rate as yields move closer to what would be considered “normal” levels. To be fair, this isn’t a hard rule, but it does give us something to consider, as the companies that are paying out 6% or more of their share price are often doing it at the very edge of what their cash flow levels can actually support.

What tells the real story is the payout ratio, and a company that is paying out 90% of its earnings as dividends is often the same company that doesn’t have much of a cushion. All it takes is one bad quarter, one interest rate move, or one unexpected capital expense, and a dividend cut happens, and investors are furious. A company that is only paying out 50% of its earnings has far more room to absorb a bad quarter or capital expense without impacting its dividend. The yield alone won’t tell an investor anything about a situation they are actually looking at, which takes us to the second scenario.

The second potential situation is the one where most 6% yields do come from, and it’s the one worth considering the most. If a stock falls drastically, then it is most probably due to the market having started pricing in the troubles behind the scenes, which is what will cause an increase in the yield.

Where 6% Actually Holds Up

There will no doubt be questions about high yields and any skepticism around these numbers would be fair, but there are some exceptions that should make the doubters feel better. Some sectors, like REITs, for example, carry structurally higher yields, and it has nothing to do with the company being in any kind of trouble. Instead, these companies are required, by law, to distribute roughly 90% of their taxable income. In other words, not only is an elevated yield normal, it’s just how it works.

The same goes for Business Development Companies, which operate under the same kind of rules of needing to distribute taxable income. For their part, MLPs in energy infrastructure also have historically supported higher payouts through long-term contracted cash flow and not earnings that can swing in either direction based on the market.

It always needs to be said that strong businesses that operate in stable industries can also support higher yields. Take a utility company that has regulated revenue and decades of consistent cash generation, which might have a similar 6% yield number as an REIT or BDC, but everything underneath is different.

What does need to hold up across the 6% number is free cash flow coverage, as there has to be enough cash left after capital expenditures are paid out to cover any size dividend. If the payout is being funded by debt, asset sales, or earnings that never actually materialize, this is a warning sign that a dividend cut is on its way.

The Questions Worth Asking

While yield might get you in the door with a stock, what’s behind the number is going to be the determining factor in whether or not you keep holding it. Ask yourself, has the dividend grown, held flat, or been cut over the last five years? The trajectory of the dividend is arguably more important than the number itself. Then ask yourself what the payout ratio looks like against both earnings and free cash flow. Earnings can be shaped in a way free cash flow cannot, which is why the latter is more critical to understand than the former.

Now ask how much debt is on a company’s balance sheet. What happens to its debt when rates climb? A heavily leveraged company that is paying out a 6% dividend while refinancing debt at higher rates is solving a math problem, and part of the solution to that problem is likely a cut to dividends.

On the math side, sector context also matters in a significant way, and it’s hard to have a dividend conversation without it. A 6% yield from a REIT and a 6% yield from a consumer discretionary company with uneven earnings are very drastically different situations that happen to share the same numbers. Treating them equally because the 6% match is there means overlooking any important analysis that might tell you how sustainable this number is for both sides.

What History Actually Says

History doesn’t always hand down a quick verdict on companies with 6% yields. Thankfully, history doesn’t say to reach for them every time, but it also doesn’t say that they always blow up either. What history does show, repeatedly, is that the yield is where questions should begin, not end. The high-yielders that have held up tend to have a few different things in common, including real cash flow, sector structures that are built to support a higher payout, and a dividend history that predates whatever pushed the yield to where it stands at or above 6%.

Ultimately, a 6% yield means more income right now, but it doesn’t fix deteriorating cash flow, and it won’t make a growing debt load disappear. If a board of directors is already having discussions about the payout, things are already in motion, and these things have a way of mattering far more than the number that made the stock look attractive to investors in the first place.

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