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stocks in companies that pay out their earnings in the form of 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 is often more than meets the eye.
High yields
Dividend returns are important: investing £20,000 at 8% generates £1,000 a year more than investing at 3%. And this can make a real difference when it compounds over time.
After 30 years, a £20,000 investment compounded at 8% returns £14,900 per year. The same investment growing at 3% generates only £1,400.
The potential rewards offered by stocks with high returns are high, but the risks are also often high. Vodafone It's a good example.
The stock has a 10% dividend yield, but it's about to be cut in half. In general, a high yield can be a sign that investors doubt that shareholder payouts are sustainable.
British American Tobacco
In the face of that, British American Tobacco (LSE:BATS) is a great example of this. The stock has a 10% dividend yield, but it's tobacco – how long can that last?
Cigarette volumes are declining and the situation could well be terminal. But tobacco companies have known this for some time and have been taking steps to adapt.
An example is ZYN – nicotine pouches produced by Philip Morris. Smoke-free products now contribute more than 35% of total revenue and have been growing impressively.
British Tobacco has a similar product: Veil – in your alignment. And if it can achieve similar success, the high-yield dividend could be longer-lasting than investors think.
Legal and general
Legal and general (LSE:LGEN) shares also offer a dividend yield of over 8%. Unlike tobacco, it is not so obvious that the life insurance industry is in terminal decline.
The big risk, however, is that the company will have to price policies that will apply for decades into the future. And that carries the possibility of future losses of unspecified magnitude.
That's the main reason why life insurance company stocks generally generate large dividend yields. There is always the risk of an unexpected (negative) surprise.
However, it's worth noting that Legal & General has a good track record of managing its operations and dividends. And if this continues, investors could do very well with the stock.
Risks and rewards
The FTSE 100 has several stocks with high dividend yields. In several cases, this reflects the possibility that shareholder returns will be lower in the future.
However, sometimes the stock market gets it wrong. And if British American Tobacco or Legal & General are underestimated, investors could reap big profits.
