High Dividend Stocks: The Cure for Low Interest Rates?
Bond yields in the U.S. and around the world remain close to all-time lows. As of this writing, the U.S. 10 Year Treasury Bond is yielding below 1.60%. With interest rates at razor thin levels, wealthy families and retirees face a challenging environment in which to invest. Traditionally, a significant portion of a wealthy family’s investment portfolio has been comprised of high quality bonds.
The good old days of bond investing are far behind us. In the late 1990’s, retirees could invest in high quality, intermediate maturity municipal bonds with yields of 4%, 5% and even 6%. In a tax-free yield environment of over 5% returns, retirement planning in a conservative fashion was relatively simple and straightforward. You did not have to take a lot of risk to make the math of retirement planning work. Today, the task of finding income in retirement is much more difficult.
In response to low interest rates, some retirees have shifted a portion of their portfolio to high dividend paying stocks. Frustrated with the meager returns and income generated in the bond market, investors have looked to blue chip stocks as a potential solution. It is hard to blame them—in an environment in which Treasury bonds yield below 2%, higher dividend yields from well established companies look quite attractive.
Is it ever a good idea to use dividend paying stocks as a substitute for high quality bonds? While tempting, the answer is a resounding “no.” Let’s explore why substituting dividend paying stocks for bonds is usually a bad idea.
Risk Level: Not Apples to Apples
Large capitalization stocks, like the blue chip stocks which typically pay a dividend of more than 2% in the Dow Jones Industrial Average and the S&P 500, are quite risky. In the investment business, we measure risk through volatility. Stocks are exceedingly more volatile than bonds. To give you an idea: a bad year in the stock market could equate to a 40% loss—the memories of 2008 are still all too real. A bad year in bonds, on the other hand, is a loss of 2-5%. In fact, the worst year for the Barclay’s U.S. Aggregate Bond Index since 1980 was the year 1994—with a total loss of 2.92%.
To give greater clarity to the difference in volatility between bonds and stocks: a bad year in the stock market could be literally ten times worse than a bad year in the bond market. When we compare the yields of bonds with the dividend yield of stocks, we are not making an apples-to-apples comparison.
When investors trade high quality bonds for dividend paying stocks, they may believe that they are only slightly changing the risk profile of their portfolio. The truth is that by replacing bonds with stocks, they are massively increasing the risk, and potential downside, of their portfolios.
Because of this recent investor shift to dividend paying stocks, certain sectors of the U.S. stock market have become quite expensive. Utilities, for example, have enjoyed a very nice run over the past few years due to their relatively high dividend yields. Consumer staples stocks have also benefitted from the investor thirst for yield. If there were ever a tactical time to not get invested in certain high dividend sectors, it would be now.
Utilities are now quite a bit more expensive than usual. On a forward basis, the S&P 500 utilities sector now trades at about 19 times earnings. Over the past ten years, the average forward P/E for the utilities sector has been 14. The overvaluation here is significant. While some other sectors of the stock market remain more fairly valued compared to long-term averages, investors need to be very careful.
If high dividend yielding stocks are not the best income solution for retirees and wealthy families, what is? While the answer is not revolutionary, it stands the test of time—a total return approach that focuses not on income generation, but a combination of income and capital appreciation. The sectors of the stock market that are not overvalued today typically have slightly lower dividend yields. That’s perfectly fine, as when we invest for total return we take distributions both from dividends and from selling appreciated positions.
By taking a total return approach, we can maintain our return expectations while not chasing investments that are both risky and overvalued. This approach seeks to maximize our investment returns, on a risk-adjusted basis.
The temptation to replace bonds with dividend paying stocks is very real. With interest rates so low, investors are justified in their frustration regarding retirement income. Still, reaching for yield in stocks can be a very bad idea. Investors are chasing a much riskier asset that has already appreciated greatly. By staying the course with a comprehensive financial plan, our clients can mitigate much of the retirement planning risk while avoiding the current desperate chase for yield.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. The price-earnings ratio (P/E) measures the current share price relative to its per-share earnings
Stock investing involves risk including loss of principal. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.