It’s one thing to work for your money. But it’s a sweeter thing to have your money work for you. Dividend stocks can be your portfolio’s reliable little workhorses.
Dividends stocks can make all the difference between a bad year and a good one. They give you cash back, which not only steadily reduces your entry cost but can also, if reinvested, grow your dividend exponentially.
For the abundance of information concerning dividends, possibly the most important consideration in the selection process is dividend sustainability. What may be a workhorse today can be a dead horse tomorrow.
Higher is Not Necessarily Better
Conducting a dividend yield search on your broker’s trading platform or the web, sorting the yield from highest to lowest, and then picking the top four or five yielders will most likely set you up for a rude awakening come ex-div. A dividend that is abnormally high is abnormally difficult to sustain.
My latest dividend search generated nearly 150 U.S. stocks paying over 10% per year, with the top pick coming in at 61.1% annualized. But before we get excited, we need to consider a very important mechanism generating these yield percentages: they are based on the last distribution amount divided by the current stock price.
The reason this stock’s yield reads so high is because the stock’s price recently plummeted by 79.9% from $18 to $3.65. The actual annual yield of $2.23 works out to just 12.4% of that $18 year-ago price. You can rest assured come the next ex-div, that 61.1% reading will be cut down to size.
If the stock price has recently taken a hit lower, it could be a sign that the company is in dire financial troubles, which could lead to a dividend cut or outright cancellation. Is the problem temporary or permanent? If management can fix it, how long will it take?
When comparing dividend yields, looking past the yield number at the stock’s chart and distribution history will give us a better indication of the likelihood of the dividend’s sustainability.
The epitome of sustainability is likely to be found in the enviable histories of 54 stocks among S&P 500 companies known as the “Dividend Aristocrats”. These are companies that have not only sustained their dividends but have actually increased them each and every year for at least 25 years.
Most of these dividend iron-men pay some 2 to 5% annualized, which is quite decent given the current low interest rate environment. There is, however, a trade off. Higher payouts mean less money for the company to expand with. You may collect a higher yield, but it will be at the cost of limited capital growth.
Since dividend companies are usually mature enterprises past their growth phase, they do not necessarily outperform the rest of the market during rallies. But they do provide better capital protection, as they tend to fall less during corrections.
The purpose of this portion of a balanced portfolio is to generate steady income that surpasses the inflation rate while keeping the principal invested relatively secure. Higher income and lower risk. Can you ask for anything more?
The Next Dividend Wave
Well, we could ask for an even higher yield – not an artificially high yield on the back of a stock’s recent collapse, but a sustainably higher one, as can be found in lending corporations that generate monthly interest from business loans, or real estate trusts that collect rents and leases from properties.
Now, there are plenty of other high yield sectors besides bond funds or lending corporations. But there is one thing that makes bonds and loans especially promising right now: the interest rate. Or better still, future changes to the interest rate.
The U.S. is about to enter the beginning of the Q.E. reduction phase and interest rate normalization, which could take some 5 or 6 years to complete. Though the change on interest rates will be slow, the impact on dividend stocks and funds will be much quicker, as we have recently seen.
Going forward, dividend paying stocks and ETFs will have to be evaluated based on their sensitivity to changing interest rates. We are about to witness the changing of the high yield guard. Out will be stocks and funds that earn their revenues from locked interest rates, to be replaced by those that use variable rates instead.
When interest rates rise, any loan, mortgage, or bond with a locked in interest rate will fall in value. Who would buy a bond locked at the old 1% when the then new prevailing rate is 2%?
A debt bearing a floating or variable rate of interest, on the other hand, will increase in value as interest rates rise, since each increase delivered by the Fed will result in more income for the variable rate debt holder.
Granted, it will still be some time before interest rates in the U.S. begin rising. The Federal Reserve’s monthly bond purchasing needs to be reduced to zero first, which hasn’t even begun yet and could take a year or two to complete. So we’re looking at possibly two more years of ultra-low near-zero rates before any increases actually begin. And even then, they will rise slowly.
This means your typical bond or mortgage fund could still be a stable, high dividend generator for a few quarters more.
But remember the lesson from the past few weeks. Traders, especially institutions with a lot of locked-rate instruments, will start migrating their holdings to variable floating rate instruments before everyone else does. We might be better off transitioning early too. The next 4 to 6 years belong to the floaters.
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What to Look For
The primary criterion to look for in a high dividend bond fund or lending company is its tie to interest rates. As the stimulus season begins to change, the sector to migrate to for high yield and capital appreciation will be the variable rate group of funds. These are often clearly identified with “variable rate” or “floating rate” right in their titles.
A second feature to consider is the duration of the company’s or fund’s debt instruments. In a rising interest rate environment, the shorter the duration of the debts are (preferably 1 to 5 years), the more the portfolio will rise in value, and the higher the stock price should rise. This is because short term loans mature and renew at higher interest rates sooner than long term loans, increasing the company’s interest revenues sooner.
There are a whole host of other considerations as well, such a trading volume, where thinly traded bond funds or ETFs can cause you to pay too much when buying and collect too little when selling.
There is also the category of fund, whether it is open-ended or closed. Open-ended funds create and redeem shares on a daily basis and will thus always trade according to the value of the portfolio (the perceived value, anyway).
Closed-ended funds, however, have a fixed number of shares put into circulation at the public offering. As such, shares will hardly ever trade according to the value of the portfolio, mostly trading either at a premium above or discount below NAV. Even so, there may be times when paying a slight premium over NAV might be acceptable – if the yield is high.
The following table shows some high volume, high yielding, variable rate funds worth looking into (click to enlarge).
The above list includes some Business Development Corporations (BDC), such as PSEC, FSC, and MAIN, plus the regional bank NYCB. The remainder are lending companies with a larger inventory of short term variable rate loans. In the new era of rising interest rates (not yet here, but quickly on its way), banks both large and small will benefit along with variable rate bond funds.
I added a “volatility” column to denote each stock’s stability relative to changing interest rates. You must decide for yourself if you prefer high volatility to enhance active trading or low volatility to secure a more passive approach.
And let’s not forget the length of time in operation. There is something to be said for longevity.
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