Are dividends doomed?
Of course not, but like just about everything else in the financial markets during the coronavirus-induced turmoil, dividend investing has taken a hit both in terms of performance and on reports of actual and speculated dividend suspensions and cuts.
For starters, the squeeze on interest rates since the Great Recession has caused many yield-seeking investors to flee into the arms of dividend-paying stocks and funds. This bid up the valuations of companies in traditionally stodgy—some would consider “safe”—sectors such as consumer staples, communication services and utilities.
But the ongoing (yet seemingly recovering) market crash has drummed home the point that equity income is just that—“equities.” So when equities plummet, so do most companies that pay hefty dividends. In other words, don’t expect your dividend-paying stocks to provide much of a cushion during a market free fall.
For example, take a look at the performance of some of the leading dividend-focused exchange-traded funds during the past month. As listed by ETFdb.com, the top five products (three from Vanguard, one from State Street and one from iShares) registered one-month declines ranging from 20% to more than 36% as of Wednesday’s market close. The eighth-largest product in this category, the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which tracks the S&P 500 Dividend Aristocrats Index comprising companies that have grown their dividends for at least 25 consecutive years, had dropped 27.1%.
In comparison, the S&P 500 ETF Trust (SPY) had lost 22.8% during that period.
“Up until this bear market, the markets have worked so well that people have been looking at equity as a replacement for bonds,” says Leo Kelly, CEO of Verdence Capital Advisors, a private wealth advisory and multi-family office firm in Hunt Valley, Md. “And there’s nothing like a bear market to wake up people to the reality of true risk and volatility. And by the way, those are different—risk is the loss of money; volatility is the movement of money.
“I think investors’ attitude toward risk will be reset,” he adds. “It’s a classic bull market mentality to say, ‘I’m an equity-income investor and it’s OK because I’m a long-term player and it’s no different than holding a long-term bond, so I’ll hold my equity and I’ll be fine.’”
But Kelly posits that mindset goes against human nature, especially for income investors who tend to be a bit lower on the risk scale than growth investors.
“So when you see a massive decline in the principal that’s far in excess of the income, the question is do you really have the wherewithal to ride this out?” he says. “Or will you make the classic mistake of turning volatility into risk by selling in a downturn?”
Kelly says the good news about the recent market carnage is that it has flung open the door to investing opportunities in beaten-down dividend-paying stocks.
“We think there will be a V-shaped economic recovery and things will get back to normal,” he says. “So companies with cash will try to maintain their dividends as best as they can, and if you buy these equities at a discount you’ll be rewarded with excess dividends.”