The Power Of Dividends In A Low-Rate Environment

The Power Of Dividends In A Low-Rate Environment

Co-written with Philip Mause

Unprecedented Low Rates

Interest rates have fallen to levels never seen before in America in recorded financial history. While the short-term rate on Treasury bills got to similar levels at various times in the last 10 years, the 10-year rate has hit levels never seen before. Even in the Great Depression, even after the fall of France in 1940, and after Pearl Harbor in 1941, the 10-year rate never got this low. In the wake of the 2008 Panic, the 10-year rate got down in the 1.5% range but never close to the current 0.6% levels. 30-year rates are also breaking records. Below is a chart of the 10-year treasury yield for the past 54 years.



Source: MacroTrends

Federal Reserve Chairman Powell has recently made it clear that these rates will persist for a long time and that the Fed will enter the market and, if necessary, expand its balance sheet in order to keep both short and long rates low. The new Fed policy will be more tolerant of inflation so that we will not likely see rate increases even when inflation goes above 2%. Barron’s has quoted one analyst who does not expect the Fed to raise the federal funds rate before late 2024.

These low rates have bled into the corporate and municipal bond markets. Municipal bonds are trading at very low yields despite significant challenges to state and local government finances (and, therefore, default risks) created by the coronavirus. Corporations are issuing bonds that yield less than 1% and the Barron’s list of “high yield” bonds currently includes several bonds yielding considerably less than 3% and none yielding more than 7%.

The Plight of Fixed Income Investors

Fixed income investors looking in the rear view mirror may feel a sense of vindication. Almost all long-term fixed income investments have traded up due to the decline in interest rates. This happens on a virtually automatic basis as, for example, bonds which were originally bought at par with 4% coupons become exceedingly valuable in a low interest rate world and, therefore, start trading well above par. The problem is that things look much less rosy for fixed income investors when they look out the front windshield.

Bonds are currently priced at very low yields and the prospect for price appreciation is remote. It is, of course, conceivable that there will be further appreciation in fixed income investments if rates decline some more and even move into negative territory. But taking advantage of this requires buying or holding bonds with maturities dated well in the future and incurring substantial duration risk.

One strategy might be to stick to only “short-term Treasuries,” buy Treasury bills and wait it out – deploying into the market only after rates go back to “normal” levels. The problem with this is, as noted above, that rates may not go back up for a very long time and, in the meantime, returns on Treasury bills will be minuscule. The yield is extremely low and cannot keep up with inflation.

So, the fixed income investor must take some combination of significant duration risk and/or default risk to get any kind of reasonable return at all. And, even taking such risks, it will take a combination of dexterity and luck to generate even a 3% or 4% total return. This will make the situation of many retirees challenging.

The problems faced by retail investors also afflict institutional investors and will result in challenges in markets for other retiree-oriented financial instruments. Because purveyors of annuities and long term care insurance generally use advance payments to acquire bond portfolios and then use the yield from those portfolios to generate the returns necessary to fund their obligations, they will face challenges and will almost certainly have to raise their prices substantially. This will make annuity investments (which are already questionable in merit) even less attractive and long-term care insurance even more expensive.

The Great Migration

So what are yield-oriented investors – especially retirees – to do? When certain doors normally open to decent investment returns suddenly close, money tends to flow with greater volume through whatever doors remain open. Thus, the bond yield drought will act like a change in rainfall patterns in the Serengeti and, like wildebeests, investors will start to look for greener pastures. Unfortunately, this may even lead to a rash of Ponzi frauds promising “safe” returns as well as other questionable schemes. However, the bulk of smart investors will pile into dividend (both common and preferred) stocks in order to obtain some decent level of yield together with a reasonable prospect for price appreciation.

Dividend stocks (as a group) provide comparatively attractive yields as well as the prospect for price appreciation and even rising yields in the form of dividend increases. The S&P 500 currently trades at a dividend yield of 1.6%, but this is misleading. The S&P 500 Index includes a number of stocks including Alphabet (GOOG) (NASDAQ:GOOGL) and Amazon (AMZN) which do not pay any dividends at all. Because the index is market cap weighted, these stocks – as well as others like Apple (AAPL) which have very low dividend yields – tend to drive down the yield on the Index as a whole. In reality, it’s fairly easy to put together a portfolio of solid stocks with an average yield of 3% or higher.

The 2% Rule

We have touched on this subject before. We pointed out in previous reports that – after the 2008 Panic – the S&P 500 tended to trade in a very tight band around a 2% dividend yield. If the yield got above 2.2%, it was almost always a strong buy signal. If it got below 1.8%, this tended to be a sell signal. Of course, this occurred during a period in which the 10-year Treasury bond rate never fell below 1.5% and was usually considerably higher. The question now is – with much lower Treasury rates – will we start trading in a tight band at a lower level?

ChartData by YCharts

As shown above, the spread between the 10-year Treasury rate and the S&P 500 dividend yield is already at a very high level – it’s unusual for the S&P 500 to provide a dividend yield nearly 100 basis points higher than a 10-year Treasury bond. This would suggest that the market will move higher and the index will start trading around a band at a lower level – 1.0% or 1.25% would still leave the S&P 500 providing much more yield than 10-year Treasuries.

Even more unusual is the spread between the 10-year Treasury yield and the S&P 500 earnings yield (which is simply the inverse of the price/earnings ratio and now stands at 3.32% or nearly 2.7% higher than the treasury yield). This gap is at an unusually high level. In the 1990s, the popular “Fed Rule” often used as a yardstick posited that this gap should be zero with the earnings yield equaling the 10-year Treasury yield. Of course, in the current interest rate environment, this would require the S&P 500 to trade at roughly 150 times earnings (and a consequent yield of 0.66%). No one really thinks that this is going to happen but the relation between the two yields suggests that the market has some room to run.

What’s an Investor to do?

Investors should re-examine traditional metrics concerning fixed income/equity investment ratios and consider a higher allocation to equities. They also should avoid getting into annuities in this climate. There are many attractive opportunities in dividend stocks – including conventional C-corps, carefully selected property REITs, mortgage REITs (or mREITs), BDCs and utility stocks as well as preferred shares. Equity and preferred stock CEFs may have additional benefits because they are allowed limited leverage and should be able to reduce interest expense on their leverage.

Investors have to be selective because the COVID-19 has had very different effects on different companies and industries, and it’s hard to tell how much of the change will be permanent. Some attractive names include Atlantica Yield (AY), an alternate energy company with long-term contracts yielding 5.6%, AT&T (T) – a blue chip now yielding 7.1%, and several attractive property REIT stocks or property REIT closed-end funds such as Cohen & Steers Total Return Realty Fund (RFI) which yield 7.5%. At High Dividend Opportunities, we lay out well researched model portfolios which provide yields well above amounts available in traditional fixed income markets.

The Power of Dividends

Dividends are extremely powerful. They are the only means of return that are guaranteed, because once a dividend hits your brokerage account, this return is locked in. The dividend cannot be retracted by market movements or by management. Each dividend receipt will boost your total return and time is on your side In case of a volatile market, you can afford to wait while you collect your income.

Not only does dividend investing generate regular cash flow needed to supplement one’s income needs, but it’s a defensive investment style that tends to outperform when markets are volatile. The reason is that by re-investing part or all of your dividends, you would be dollar-cost averaging your purchases and therefore increasing your future income. A portfolio diversified with a high allocation to preferred stocks and high-dividend stocks is a profitable trend being embraced for those looking for income in a yield-less world.

Invest with the Best! Join us to get instant-access to our model portfolio targeting 9-10% yield, our preferred stock and Bond portfolio, and income tracking tools. Don’t miss out on the Power of Dividends! Start your free two-week trial today!

Disclosure: I am/we are long AY, T, RFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, Trapping Value, PendragonY, Preferred Stock Trader, Long Player, and Philip Mause all are supporting contributors for High Dividend Opportunities.


Originally published on Seeking Alpha

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