Investing in high dividend yield companies is a great way of building wealth, particularly when those dividends are reinvested and compounded over a long time. However, investors need to be wary of dividend traps.
Dividend traps are usually created when a company's share price decreases over a period of time due to a change in circumstances or a negative outlook which makes its historical dividends look high in relation to the lower share price.
The dividend yield won't factor in this change in circumstances and its potential impact on future dividends. This then creates the dividend trap i.e. investors attracted to a company with a high dividend yield that is not sustainable.
Investors who use the dividend yield to screen stocks will come across Genworth Mortgage Insurance Australia (ASX: GMA) which is currently trading at a 9% yield and wonder whether Genworth will go on to become a dividend king or if this is a dividend trap.
Genworth is a provider of Lenders Mortgage Insurance (LMI) in Australia. Banks require borrowers who purchase property without a sufficient deposit (typically less than 20% of the house value) to purchase LMI from insurers such as Genworth.
Genworth's share price has decreased by 20% over the last 5 years and the following could be indicators that it may be a dividend trap:
- Australia's housing market has been the subject of much debate and credit agency Moody's recently downgraded Genworth citing high and rising household debt as a risk. Should borrowers default on their home loans on a large scale as has happened in the USA, Spain and Ireland, Genworth's claims experience could skyrocket.
- Genworth is highly dependent on banks such as National Australia Bank Ltd. (ASX: NAB) as its major clients to generate premiums. The company recently announced a one-year extension to November 2018 in its contract with NAB. The contract represents 10% of Genworth's FY 2016 gross written premiums. Should Genworth fail to renegotiate that contract (other insurers such as QBE Insurance Group Ltd (ASX: QBE) also provide LMI for NAB) that would have a significant impact on earnings. The major banks also have the option of self insuring as opposed to contracting Genworth.
Foolish takeaway
The uncertainty facing Genworth would make me cautious. Investors might want to consider looking elsewhere.
