Only Game In Town?
Even as the Fed starts the process of rate hikes, many expect the central bank to move “low and slow” in the next few years, suggesting dividend yields will remain comparatively more attractive. According to the CME Group, the federal funds rate has an 85% chance of remaining at or below 1% by February 2017. The current dividend yield on the S&P 500 stands at 2.1%, according to S&P’s Silverblatt.
It’s worth noting that the market’s dividend yield has stayed in a tight 1.9%-2.1% range since 2010, suggesting that dividends have grown in lockstep with the S&P 500 index. To keep pace with the broader market, companies have had to increase the average payout ratio (the amount of net profits dedicated to earnings) from 28% in the summer of 2010 to a recent 46%.
That’s still below the average dividend payout ratio of 60% that was tallied between 1871 and 2015, according to Jeremy Schwartz, the director of research at WisdomTree Investments. Over that time, the average dividend yield was 4.4%, more than twice the current market yield.
Schwartz sees an ongoing balance between both dividends and buybacks. Firms in the S&P 500 spent $572 billion on buybacks last year, which has a beneficial impact on dividend growth rates in the form of smaller share counts. “Investors should be indifferent to dividends and buybacks,” says Schwartz, while conceding that some investors need a specific focus on the dividend part of the equation as they seek out income.
Schwartz also remains unconvinced that any Fed move to raise short-term interest rates will have a corresponding impact on market-driven interest rates such as the 10-Year Treasury, which is a key gauge against which dividend yields are measured. He thinks the market remains fixated on safe haven assets, which has been a secular force driving down longer-term yields. That trend may be reinforced by an “aging investor class” that will become increasingly risk averse.
Drilling Down Into The Action
For investors that have been in the market for a long time, dividend-paying stocks were most often found in two sectors: utilities and financial stocks. But thanks to the economic crisis of 2008, banks virtually disappeared from the dividend-paying scene for a while. Back in 2007, the financial sector accounted for 33% of all dividend payments in the S&P 500. That figure has been rebounding, but stands at only 16% today.
A slew of new regulations regarding balance sheet strength has forced banks to mostly forgo the traditionally large payout ratios of the past. And until interest rates rise at a robust rate, the net interest margin at banks is likely to stay too weak to support their strong cash-flow growth.
Utilities also aren’t doing an especially good job of luring dividend-seeking investors these days. Back in 2012, the average utility sported a 4.4% dividend yield. Even though their payouts didn’t keep pace with the subsequent bull market, the sector’s dividend yield has been steadily falling to a recent 3.4%.
Investors looking for dividend growth should check out an often overlooked sector: tech stocks. While these firms rarely supported dividends before 2008, they have been posting especially impressive dividend growth rates since then.
The key theme for these robust dividend growers is strong cash flow and high levels of cash. The flip side is that tech stocks such as Microsoft, Apple and Intel offer yields of less than 4%. Many investors are tempted by much higher yields in riskier sectors such as energy, “but you could lose a lot more in terms of falling stock prices than you might gain in that higher yield,” says Silverblatt.
A Preference For Preferreds?
Investors may also want to consider preferred stocks, which tend to offer higher yields than common stocks and are also more likely to maintain the dividends throughout economic cycles, thanks to their senior status on the payout hierarchy.
“We’re starting to see a client preference for preferred dividend payors, especially those that will transition from fixed-rate payouts to floating-rate payouts,” says Anne Kritzmire, managing director of closed-end funds at Nuveen Investments. You can find many preferred stocks with dividend yields in excess of 7% at Dividend.com.
The Fund Route
There is also a broad array of dividend-focused ETFs and mutual funds to choose from as well. Many of WisdomTree’s ETFs have a dividend theme. For example, the WisdomTree U.S. Quality Dividend Growth Fund (DGRW) focuses on stocks with strong earnings growth and high returns on equity and assets. The WisdomTree High Dividend ETF (DHS) focuses on slower growing yet stable stocks such as AT&T, Exxon Mobil and Verizon, all of which have dividend yields of more than 3.3%.
The Nuveen Tax-Advantaged Dividend Growth Fund (JTD) is a closed-end fund that takes a unique approach to robust dividend payouts. The fund is built to deliver 7% to 9% annual distributions, which come from the dividend payments of stocks in the portfolio, from some extra yield by preferred stocks in the portfolio and from income produced by the writing of call options on stocks in the portfolio. The fund, which carries a four-star rating from Morningstar, has risen 10% in value, on average, over the past five years, in addition to have a current 8.6% distribution rate.
A slow rise in interest rates shouldn’t have too much of an impact on dividend-paying stock prices. However, a more rapid rise in interest rates could spark an exodus from these stocks as investors lock in relatively strong fixed-income yields without taking on the risk that equities can carry.