It’s easy to become seduced by a good-sized dividend yield. That’s why AT&T and Verizon both seem so bewitching: these fiercely competitive US telecom players each offer a nearly 8% dividend yield – a nice-to-have payout in uncertain times like these. But when it comes to dividend yield investing, you’ll always want to tread carefully: those come-hither returns can be dangerous. Here are the questions you want to ask before giving into their charms…

How safe is the dividend?

You can assess this in three ways. And it basically comes down to the past, present, and future.

The past: how good is the company’s dividend track record?

For AT&T, it’s not the best look, unfortunately: the firm cut its payout as recently as last year. But before that, the firm’s dividend held steady or actually grew for over 20 years. As for Verizon, well, you’d have to go all the way back to 1998 to find its last dividend cut. And for me, that’s long enough ago not to hold that against it.

Overall, both companies boast good dividend records. And that’s important, because if there was a patchy record, say, with dividend cuts every other year or so, I’d be tempted to declare both firms immediate no-gos, at least as far as those dividend hopes are concerned.

The present: how well is the dividend covered?

Now let’s look at how well-funded the dividends are right now.

This chart shows each firm’s dividend payment as a fraction of its free cash flow (that’s cash left over after all everyday expenses, as well as including outlays for maintaining and upgrading their networks).

Dividend payments as a percentage of free cash flow for AT&T, in blue, and Verizon, red. Source: Koyfin.

With few exceptions – 2016 and 2017 for Verizon, and 2014 for AT&T – each company’s dividend payment was comfortably smaller than its free cash flow: usually below 75% and often at or below 50%. So, other than for those few years, both firms raked in enough money to easily pay dividends if they wanted to, which, of course, other than last year for AT&T, they did.

The future: how certain are the company’s prospects for paying future dividends?

It’s also important to think ahead. It’s one thing to determine that the dividend is safe now, but what about over the coming years? Sure, both firms generate enough cash to pay their dividends, but there are other ways to spend that cash, and at least two of those could be more pressing than a shareholder bonus when push comes to shove. The first one is debt levels and the second is capital spending – those pricey outlays for network maintenance and upgrades. Let’s take each in turn.

This next chart shows each company’s net debt compared to its earnings before interest, tax, depreciation, and amortization (EBITDA), over time. This so-called leverage ratio is used as the acid test for a company’s level of indebtedness.

Net debt to EBITDA, for AT&T (blue) and Verizon (red). Net debt is a firm’s long-term debt minus its cash on the balance sheet, and EBITDA is a cash-based profit figure. Source: Koyfin.

What’s notable here is that this debt-to-profit ratio has been getting worse over time for both firms. At just over a 3x multiple, it’s not something to panic about, especially given the predictable nature of the business. But it’s a bit of a turnoff: I’ve always had a rule of thumb that a leverage ratio below 2.5 is fine, and anything above it is, well, not fine, to be frank. What’s more, the trend isn’t great either. If this leverage ratio continues to creep higher, say, to the 4 neighborhood – either because profit falls or debt rises – then there’s a real risk that some cash flow will have to be diverted into repaying debt. That’s a particular concern given the cost of debt – i.e. interest rates – has gone up a lot.

So, that’s debt levels. Now onto capital spending, where the key stat is capital spending to sales.

Capital spending as a percentage of sales for AT&T (blue) and Verizon (red). Source: Koyfin.

Again, I’m afraid this isn’t exactly a pretty picture. The explosion of streaming on our phones has left both firms needing to pour more and more money into their networks over the past few years. And at this point, capital expenditure (capex) to sales is about as high as it’s been at any time in the past decade.

So, combining these last two charts (debt and capex) I’m left wondering whether the demands on both firms’ free cash flow could leave those dividends looking vulnerable at some point in the future. Ultimately, if it’s about immediate survival (in the case of repaying debt) or survival in the future (having a network that’s up to scratch), the dividend might have to take a back seat.

What’s the bottom line, then?

At this point, it’s worth taking stock (or, not, as the case may be). The share prices of both telecom stalwarts have been shockingly bad for a long time. Verizon’s stock is back at levels last seen in 2010 and AT&T is languishing at a three-decade low. And that shouldn’t come as a shock. Dividend investors tend to run away from anything less than rock-sure payouts, which explains a lot of the weakness in the shares. But, hey, that’s why there’s an 8% dividend yield and the reason for this entire analysis.

You essentially have two options. The first is to accept that there’s a risk that Verizon and AT&T slash their dividend at some point, even though those payouts look safe for the immediate future. And, with these stocks so low, it’s likely that investors have already “priced in” the likelihood of a dividend cut. However, even at half the current dividend payout, the shares would offer a roughly 4% yield, and that’s still decent. What’s more, if a cut is priced in, there’s a chance the stock prices would rally on the news once it happens – a big cut might free up enough spare cash to pay off debt or support even more investments. And that, on balance, would be good for the firms’ futures.

The second option, of course, is to steer clear. And to be honest, that’s how I’m leaning. For one thing, I’m always wary of capital-intensive businesses that need to plow more than 10% of their sales (16% in the case of AT&T and Verizon) to maintain and grow. For another, I think it’s smart to avoid any business with elevated debt right now unless there’s a fast-track strategy to repay it – one that doesn’t involve a dividend cut.

But you can decide for yourself whether to pass on these stocks or give them a ride in your portfolio. You can also bookmark this analysis and use it to assess any other dividend-paying stock that tempts you.