Dividend shares are popular among investors seeking to create a steady stream of passive income. They’re usually mature companies with a proven track record and a solid business model.
As such, these equities are typically more stable and less prone to wild share price fluctuations.
Yet, while size and maturity can be beneficial, it also commonly comes paired with elevated debt levels. That’s because cash-generative enterprises can afford to take on external financing to continue to fund operations instead of diluting shareholders.
However, with the Bank of England hiking interest rates to their highest levels since 2008, debt in 2023 is suddenly very expensive. And for the firms that became heavily reliant on loans to fund expansion, a tough time may lie ahead. It could even spell trouble for shareholder payouts.
This looming concern is why so many FTSE stocks are now offering higher yields this month. So is this a sign to steer clear until the storm blows over? Or are investors looking at a rare opportunity to propel or kickstart a secondary income stream? Let’s explore.
High debt isn’t necessarily a problem
Debt is often perceived as a bad thing to have hanging over someone’s head. But in reality, loans are a tool that, when used correctly, can be massively advantageous. After all, a firm that needs immediate access to capital to fund a game-changing project could borrow the money to position itself to thrive in the long run.
There’s valid concern surrounding firms that have been strategising on the assumption that interest rates would stay near zero. So now that British rates now stand at 5.25%, debt-ridden companies are obviously in trouble, right? Not necessarily.
Debt can come in many forms. However, every loan can typically be categorised into either fixed or floating. Like any other loan, fixed means that regardless of movements in rates, the interest paid on the loan doesn’t change. Floating, or variable, is the opposite. The latter is usually the one that causes the most trouble.
Knowing which type of debt makes up the bulk of a firm’s outstanding loan book can provide far more insight into whether dividends are actually in jeopardy. And even if a corporation is riddled with floating rate debt, this may be completely fine if it generates plenty of free cash flow.
Time to buy?
In most situations, seeing an income stock offer a high-single or even double-digit yield can be a giant red flag. Don’t forget that yield is a function of share price. And if it’s been pushed up as a result of a falling market capitalisation, it can be an early indicator of an upcoming dividend cut.
However, there are always exceptions. And the number of these are usually far higher during volatile market periods like the one we’re currently experiencing.
That’s why I believe now is an excellent time to start adding dividend shares to my portfolio.
