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Shares in companies that pay out their earnings as dividends can be great sources of passive income. And the FTSE 100 has some stocks with dividend yields of 8% or more.
Compounding a £20,000 investment at 8% per year generates a return of £3,198 per year after 10 years. But investors should be careful – there’s often more than meets the eye.
High yields
Dividend yields are important – investing £20,000 at 8% generates £1,000 per year more than investing it at 3%. And this can make a real difference when compounded over time.
After 30 years, a £20,000 investment compounded at 8% returns £14,900 per year. The same investment growing at 3% generates just £1,400.
The potential rewards offered by stocks with big yields are high, but the risks are often high as well. Vodafone is a good example.
The stock has a dividend yield of 10%, but this is about to be cut in half. In general, a high yield can be a sign that investors doubt the shareholder payments will be sustainable.
British American Tobacco
On the face of it, British American Tobacco (LSE:BATS) is a great illustration of this. The stock comes with a 10% dividend yield, but it’s tobacco – how long can that last?
Cigarette volumes are in decline and the situation may well be terminal. But tobacco companies have known about this for some time and have been making moves to adapt.
One example is ZYN – the nicotine pouches produced by Philip Morris. Smoke-free products now contribute over 35% of total revenues and have been growing impressively.
British Tobacco has a similar product – Velo – in its lineup. And if it can achieve similar success, the high-yielding dividend might be more durable than investors realise.
Legal & General
Legal & General (LSE:LGEN) shares also come with a dividend yield over 8%. Unlike tobacco, it’s not so obvious the life insurance industry is in terminal decline.
The big risk, though, is the business has to price policies that run for decades into the future. And that brings the potential for future losses of unspecified magnitude.
That’s the main reason shares in life insurance companies generally come with big dividend yields. There’s always the risk of an unexpected – negative – surprise.
It’s worth noting, though, that Legal & General does have a good record of managing its operations and its dividend. And if it continues, investors could do very well from the stock.
Risks and rewards
The FTSE 100 has several stocks with high dividend yields. In a number of cases, this reflects the possibility of shareholder returns being lower in the future.
Sometimes, the stock market gets things wrong, though. And if it’s underestimating British American Tobacco or Legal & General, there could be big returns for investors.