In long-term, income-focused strategies, investors may have to shift their allocations over time as portfolio components cut or eliminate their dividends. In the current environment, that would result in replacing an old source of income with a more expensive source of income, or moving into higher risk assets to replace lost yield.
Rising Rates
The jury’s still out on how the Fed’s experiments with monetary tightening and balance sheet reduction will impact dividend strategies. The U.S. central bank is expected to raise interest rates at least two to three more times in 2018, which would bring the interest rates of short-term debt close to the S&P 500’s dividend yield.
“Right now, yields relative to history are lower than average, but in many cases the stocks are yielding more than bonds of the same company,” says Altfest. “When interest rates rise meaningfully, those dividend-yielding stocks are going to be hurt as investors move to the bonds. They’re going to decline in price, and over a longer period they’re not going to grow like the rest of the equity market. People stretching for yield will find themselves with declines in principal as interest rates rise.”
If interest rates were to spike, causing a stock market crash or a wave of corporate bond defaults, companies may struggle with the decision to maintain their dividends or to cut them in favor of investing elsewhere, says Kirby.
The liquidity risk of dividend strategies rises as the average rates on low-risk bonds and CDs eclipse the average rates paid by equities and fewer investors demand dividend equities.
“As the economy starts to transition and central banks start unwinding their monetary policies, a lot of these asset classes that have prospered under this easy money environment may be open to some downside principal risk,” says Don Riley, CIO at the Wiley Group. “Reaching for yield now may result in paying a price later that isn’t apparent today.”
Taxation
Dividends can be detrimental to investment results outside of health savings accounts (HSAs) and Roth IRAs. In Cambria’s analysis, dividend-paying stocks only outperform within tax-exempt accounts. Within taxable accounts, investors running value strategies could add 12 basis points of annual compounding by avoiding the highest-yielding quintile of equities.
“Asset location is very important,” says Jim Baird, CIO and partner at Plante Moran Financial Advisors. “Some investors will have a good chunk of assets in a Roth IRA, and that takes the tax issue with dividends off the table. It’s a matter of knowing what the tax consequences are of taking the distributions. We would like to shield as much taxable income as possible and keep tax-efficient assets in a client’s account.”