In just the last six months, the convergence of historically low Treasury yields, increasing stock market volatility, and the looming threat of a recession has been creating a challenging time for income-seeking investors.
We believe that it is critically important for retirees and pre-retirees to understand the risks of reaching for higher yields and to consider alternative strategies for creating lifetime income sufficiency.
Right now, a rising-dividend strategy may be the best option for weathering the storm while generating a sustainable and growing income.
Since the 2008 financial crisis, income-oriented investors have been challenged by historically low yields that have lasted much longer than predicted. Even as the Federal Reserve began to ratchet up rates in 2015, 10-year Treasury yields have not caught much upside traction. They have recently slipped below the yield inversion line which, historically, has been a harbinger of an oncoming recessionary cycle.
The good news is inflation has been largely held in check, hovering near the low end of the Fed’s 2% to 2.5% target range. The bad news is that, at 1.9%, inflation is currently outpacing the 10-year Treasury yield which has fallen to 1.69% as of October 31, 2019. But for retirees, costs for housing (independent living facilities), healthcare, and leisure can rise at a much faster rate.
So, if that’s the current environment and foreseeable outlook, where can investors go to source income outside of Treasuries or CDs?
Corporate Bonds. While corporate bonds may offer higher yields, risk in the credit markets is on the rise. If you believe interest rates will rise in the future, you can expect corporate bond prices to decline. However, the real risk in holding corporate bonds is in the potential deterioration of the credit markets themselves. Low rates over the last decade have enticed companies to pile on debt to the tune of $9 trillion by 2018. Another $15 trillion of corporate debt will need to be refinanced over the next several years in the midst of market volatility.1
Preferred Stocks. Preferred stocks are generally coveted by yield-seekers for their high yields and relative safety as compared to common stocks. However, they perform similarly to bonds in that they are interest-rate sensitive and don’t have the upside potential of common stocks. In addition, the dividend payout on preferred stocks is typically fixed, whereas the dividend on common stocks has the potential to increase.
Real Estate. Real estate has long been a popular income-producing investment, considered to be stable with the potential for increasing cash flow and capital appreciation. However, owning real property has its challenges for people who never envisioned becoming a landlord. Real estate investment trusts (REITs) are a good alternative. However, REIT share prices are also interest-rate sensitive, tending to fall when rates rise as well as during real estate market downturns.
While all investments have their pros and cons depending on the investment profile of investors, in certain economic and market environments, such as we are now experiencing, the cons can outweigh the pros for bond investors. However, in an environment of stubbornly low interest rates and stock market uncertainty, the pros may outweigh the cons with a rising dividend strategy.
We believe that investing in high-quality companies with long operating histories is the safest way to invest in stocks during economic and market downturns. That’s because companies with strong balance sheets, steady revenue streams, and healthy cash flows are typically better able to fund their operations during prolonged periods of economic weakness. For that reason, their stock prices tend to fall less than the broad market during market downturns.
According to a study published in the Financial Analysts Journal, “Focusing on dividend-paying stocks significantly reduces risk, independent of investment style. This finding is true for value and growth portfolios as well as small-, mid-, and large-cap portfolios.” 2
While high-quality dividend stocks are not likely to generate market-leading returns in any given year, the portfolio will lose less money on the downside, which is the key to growing portfolio value over the long-term.
Investing in dividend stocks is not all about generating outsized returns; rather it is about generating a rate of return meaningfully greater than the rate of inflation while preserving capital during protracted market declines. And, because dividends are always positive, they act as an effective counterweight in down markets.
When considering dividend investing as part of an income strategy, there are two key concepts many advisors and investors tend to forget – that the cash income from dividends doesn’t fall just because stock prices fall. And cash dividend payouts are generally not linked to the direction of interest rates.
In fact, according to Standard & Poor’s, of the more than 1,000 companies that currently pay dividends, 53 have increased dividends every year for the last 25 years, regardless of the direction of the market or the economy.3
Through severe market and economic turmoil, companies with a long history of increasing their dividend payments have generated increasing income per share for their investors.
Consider the following hypothetical example, which we call the “Power of Five”: You invest $100,000 in a stock fund with a dividend payout of 3.5% that increases by 5% every year. You reinvest the dividends and the share price remains unchanged. Your first-year income is $3,500. Should the fund continue to perform as expected and increases the dividend payout 5% per year, your dividend income would more than double every nine years as shown in the example below.
Not all dividend stocks are created equal. As with any investment class, it’s important to establish strict criteria for selecting the securities that best match your profile and meet some standard of quality.
Chasing the highest yielding dividend stocks can be as risky as investing in junk bonds. Over the long term, companies with an established record of uninterrupted dividends, a clean balance sheet, and a positive earnings outlook, may outperform the higher-yielding investments in terms of both dividend income and capital appreciation.
We continue to believe that investing in stocks that have historically and consistently increased their dividends may provide an excellent opportunity for investors to produce growing and sustainable income.
Integrity Viking Funds, founded in 1987, is a boutique asset manager with a focus on income producing strategies. Integrity Viking Funds manages assets for individual investors, registered investment advisors and broker/dealers. The Funds are available at more than 500 financial intermediaries in the U.S.
For more information, please contact Trey Welstad, CFA, Portfolio Manager, at 701-712-8821 or firstname.lastname@example.org
1 CNBC.com. There’s a $9 trillion corporate debt bomb bubbling in the US economy.
2 cfainstitute.org. The Surprising Power of Dividends (In Practice).
3 MarketWatch.com. These dividend stocks beat the Dow and S&P 500 through thick-and-thin.