The low yields offered by most fixed income products have driven many investors to look for income in other places—including the equity front. And for the time being, dividends have become a more important part of equity returns as stock price increases have lessened. Investors seeking income should consider sectors with the potential to deliver it.

Before starting, however, remember that equities do not, and should not, replace fixed income in your asset allocation. Equities have a different risk profile from fixed income products, and replacing one with the other would change the risk characteristics of your portfolio. Also, remember that dividends are not guaranteed—they can be adjusted, even suspended, at any time. Having said that, equities can be a nice source of income, and investors may want to look closer at the dividend dynamics of sectors.

When searching for income, investors typically run to the telecom and utilities sectors, and for good reason. In the third quarter of 2015, for example, these were the two sectors with the highest dividend yields; they also posted the highest average yields over the past decade.1 But investors should still tread carefully. Although both sectors have performed well so far this year, given falling interest rates and global growth concerns, we believe valuations are stretched and that a pullback is possible. Additionally, both telecom and utilities make up a relatively small percentage of the market, and their contributions to the total dividends paid have dropped precipitously over the past 20 years.

In contrast, both technology and financials have had a rising influence on total dividends paid—3Q's yield for both sectors showed solid increases over their 10-year averages1. Additionally, technology and financials were also the leaders in the third quarter of 2015 in terms of total dividend payments, while financials led all groups in terms of year-over-year dividend growth, at 15.8%.1

Investors should also pay attention to the payout ratio—the percentage of net income paid out in dividends—for the various groups. This can indicate how sustainable dividend payments may be. For example, in the third quarter of 2015, the telecom sector's payout ratio was around 130%, meaning telecom companies paid out more than they earned. Given that the telecom sector’s 10-year average payout ratio is around 80%, this suggests there is little cushion to support continued payouts at this level. By contrast, both tech and financials have payout ratios just above 20%.1

As for the energy sector, one should be cautious in the current environment. When a group has seen extreme moves it can skew the dividend picture. At the end of last year, energy showed a yield of close to 4%, well above the 10-year average of 2%. However, this was largely due to the rapid drop in prices—it typically takes a bit more time before companies cut their dividend payments, which we’re now beginning to see. This is also apparent in the payout ratio, which jumped from an average of about 20% over the past 10 years to more than 110% in 3Q1, which is clearly unsustainable.

Dividends can be a nice source of income and are likely to be an important piece of total equity return, at least for the near term. Investors can benefit from understanding the structure and trends in the various sectors, to help them make wise investing decisions.

Brad Sorensen heads market and sector analysis for the Schwab Center for Financial Research.

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