A high yield on an ASX dividend share can be a tempting metric to consider when choosing your next investment. But not all high yielders make good investments. A company's dividend yield tells us what dividends a company has paid, not what it will pay in the future.
And companies have absolutely no obligation to keep their dividends at the levels of previous years. As such, it's possible to get caught out buying a share for a seemingly high dividend yield, only for the company to cut said dividend after you buy.
This undesirable situation is known as a dividend trap.
Avoiding a dividend trap
It can trap investors because if a company cuts its dividend, it can be an indication that it is under financial stress. As such, the dividend cut might be accompanied by a share price fall. And now our investor has lost capital in their investment, leading them to be 'trapped' if they don't want to sell out and crystallise a loss.
That's why all ASX shares with relatively high yields should be examined very closely if an investor wants to avoid this situation.
But let's discuss three ASX dividend shares that I think could be in danger from this very trap.
The first is Magellan Financial Group Ltd (ASX: MFG). Magellan paid out $1.79 in dividends per share last year, which gives the company an eye-watering trailing yield of 19.2% on current pricing.
However, Magellan is a company that is currently under the pump. Its funds under management (FUM) have been falling precipitously over the past 12 months.
Over the six months to 31 December 2021, Magellan has an average of $112.7 billion in funds under management. But its latest figures from December 2022 had the company's FUM down to just $45.3 billion. That was down from $50.2 billion just a month earlier.
Fund managers' profits are directly tied to how much capital they can charge their fees on. As such, it's looking highly unlikely that Magellan will be able to pay anything close to $1.79 per share in dividends in 2023.
Thus, I think Magellan is a classic dividend trap right now.
2 more high-yield ASX shares I'm avoiding
Fortescue Metals Group Limited (ASX: FMG) is another potential dividend trap in the making. Record iron ore prices in 2021 and 2022 saw Fortescue dial up its dividends to a record $3.58 and $2.07 per share respectively. On 2022's numbers, Fortescue shares offer a trailing dividend yield of 13.4% today.
Fortescue is an extremely well-run company, without the kind of existential problems that Magellan is dealing with right now. However, it is still a price taker at the end of the day. Fortescue's profits are explicitly tied to the price of iron ore.
While iron ore is still high by historical standards at US$120 a tonne today, the base metal remains a long way from the US$200-plus per tonne prices we were seeing in 2021.
Because of this, I think Fortescue's dividends will struggle and investors might have to put up with lower payments this year. There are probably still healthy dividends coming to shareholders in 2023, but I wouldn't be banking on a 13.4% dividend yield.
Finally, let's check out WAM Capital Limited (ASX: WAM). This popular listed investment company (LIC) is a favourite of many income investors.
But the WAM Capital dividend is looking rather shaky on the latest figures. For the past few years, this company has paid out 15.5 cents per share in dividends. That leaves it with a trailing yield of 9.7% right now.
But the company's latest updates tell us that this LIC only has 11.9 cents per share left in its profit reserves. That's looking dangerously low. So I wouldn't be relying on this company to maintain its dividends at the old levels going forward.
