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Loading up a Stocks and Shares ISA with high-yield dividend shares can be one way to try and build passive income streams.
It can be a very lucrative approach – but there are also some potential pitfalls. Here are three things to watch out for when using this strategy.
Diversification always matters
Look at a list of the highest-yielding shares in the FTSE 100 right now and you will spot some common themes. The top 10 is dominated by financial services companies, property businesses and tobacco shares.
Look at the FTSE 250 and there is a similar phenomenon at play albeit with a different emphasis. Renewable energy forms one of the big themes there.
Just because a particular sector has multiple high-yield shares is not necessarily a red flag. It can reflect investor concern about dividend sustainability, as in the case of renewable energy shares in the light of uncertainty about future energy policy. But time will tell how well-founded such concerns are.
That can mean a certain sector offers bargain-priced high-yield shares.
But it is also a salient reminder of why it is always important to balance an ISA through diversifying across multiple business areas. Too large a concentration in one can be risky if that sector’s fortunes change.
Know what you’re buying
It sounds obvious, but when buying a share it is important to know about the business. That way, you can assess what its prospects are and how attractive its current price looks.
For some high-yield shares this can be fairly simple. I feel confident I can assess cigarette maker British American Tobacco (LSE: BATS), for example.
Other shares may take more effort. Financial services firms can have complex balance sheets that are nonetheless important in understanding their financial prospects.
Some high-yield investment trusts have large portfolios but fund their dividends not just from dividends they receive, but also from asset sales. Understanding the sustainability of such an approach matters.
Look at where the dividend may go
That brings me onto a third point to ask when looking at a share as a possible purchase for an ISA: how sustainable is the dividend?
British American Tobacco provides an example here. Unlike rival Imperial Brands which cut its dividend sharply in 2020, British American has a track record of annual dividend growth stretching back decades. The current yield is 5.8%.
The FTSE 100 firm aims to keep growing its dividend per share annually, but neither management aspiration or past performance are guarantees of what to expect in future from a share.
With fewer people smoking cigarettes, there is a risk that revenues and profits will fall. That could hurt the sustainability of the dividend and lead to the sort of cut we saw at Imperial.
Cigarette sales volumes at British American are already in steady decline. Its portfolio of premium brands like Dunhill can help here, as it gives the company pricing power. Pushing up selling prices can help mitigate the profit impact of lower volumes.
The company has also spent years developing its non-cigarette business. As a long-term investor, I continue to see British American Tobacco as a high-yield share worth considering.
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Christopher Ruane does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
