Beware banks bearing high yields. The dividends on offer from a number of blue chip European and US banks look mouthwatering. Citigroup, Royal Bank of Scotland and Barclays, for example, all have dividend yields well above 6 per cent. Those look seriously tempting when 10-year Treasuries are offering 4.2 per cent.

US banking chart

But investors should think twice. These yields reflect cratering share prices. The recent credit market turmoil has led to large mortgage-related writedowns, as well as a loss of confidence in banks’ balance sheets. That fear could be overdone. For optimists, it is possible banks will clean up their balance sheets and avoid further big losses, making this a buying opportunity.

However, it looks likely that at least some banks are a value trap. Earnings are under threat, both from writedowns and rising loan-loss provisions. In October, for example, analysts expected US financial earnings to rise 7 per cent in the fourth quarter. Now they expect a fall of 20 per cent, according to Thomson.

At the same time, some banks’ balance sheets have ballooned, as they have been forced to hang on to leveraged loans and bring assets back on their books. That means they need more capital.

Selling assets to achieve that eats into profit growth. If they instead try to rebuild capital from earnings, it increases the risk of dividend cuts. Citi estimates European banks are paying out just more than 40 per cent of earnings in dividends. But that equates to 85 per cent of free cash flow (defined as earnings minus the capital that has to be set aside to fund balance sheet growth). That does not leave much room for manoeuvre.

If credit markets do not improve, some dividends look vulnerable. Alternatively, banks could raise capital and retain the dividend, diluting shareholders anyway. Either way, today’s healthy dividend yields could yet prove to be Trojan horses, lulling unwary investors into a false sense of security.

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