Are Dividend Stocks Still a Good Bet?
It's no secret that interest rates have been ultralow for years. Even before the spread of COVID-19 worldwide and global central banks boosted quantitative easing efforts to stabilize their ailing economies, interest rates sat at historically low levels.
The chart below[1] from the International Monetary Fund (IMF) reveals that interest rates in the U.S. have been below 2.0% for the better part of the past decade. With the Federal Reserve committed to keeping the federal funds rate near zero until at least 2023, one can presume that interest rates will remain ultralow for the foreseeable future.
In this environment, many market pundits have proclaimed the merits of investing in dividend stocks. You're probably already familiar with dividend stocks, but let's briefly review what a dividend stock is and why they're attracting Wall Street's attention right now.
Simply put, dividend stocks are stocks that reward their shareholders with quarterly, semi-annual, or annual cash payments. These cash payments are determined based on management's strategy for deploying the company's cash flow.
Many income investors focus wholly on a stock's dividend yield, defined as the annual dividend divided by the stock price. Still, it's essential to understand that buying stocks simply because they have a high dividend yield is a risky business.
A high dividend yield can often be a warning sign that the market either thinks the dividend payment is at risk or the company itself is at risk. Investors need to do their homework before buying stocks based solely on it paying a high dividend yield.
However, for the most part, stocks that pay nice dividends are attractive to investors. They provide an immediate and ongoing source of cash flow, as well as the potential for capital appreciation.
Dividends are generally considered guarantees by management to investors. If management decides to pay a dividend, the market assumes that payment will continue forever. Because of this, when a company cuts its dividend, it's a big red flag to investors.
Several stalwart companies are well-known dividend-paying stocks and favorites among income investors. A few examples include Johnson & Johnson (JNJ), Procter & Gamble (PG), and Exxon Mobil (XOM), as they have paid dividends for decades.
Consider this: Johnson & Johnson has upped its dividend every year since 1963, and in the past five years alone, its dividend increased by 41.3%. Procter & Gamble has paid a dividend since 1891, and it has boosted its dividend for 61 straight years. Exxon Mobil has rewarded its shareholders with dividends since 1882, increasing its dividend at an average annual rate of 6.3%.
All three of these stocks also boast good dividend yields. Johnson & Johnson and Procter & Gamble both have a current dividend yield of about 2.4%, while Exxon Mobil has a 6% dividend yield. When you consider that income investors' other choice for "reliable" income is Treasury yields, but the 10-year Treasury has remained below 2% for more than two years, it's no surprise that many retirees and other yield-hungry investors are turning to dividend-paying stocks.
As we look forward, the big question becomes: how will dividend stocks respond when interest rates on bonds start moving up? I think it would be fair to say that the attractiveness of dividend yields will fall as rates on bonds rise.
Despite the belief that dividends on stocks are relatively safe, an investor in dividend stocks still assumes the risks inherent with any stock investment. For investors looking for safety along with some income, bonds will become much more attractive as interest rates rise. So, we would expect demand for higher dividend yield stocks to fall once interest rates start rising.
Ultimately what makes most sense depends on your unique situation. At Nicollet Investment Management, we build customized portfolios to fit those needs. Give me a call to discuss how dividend stocks may or may not fit into your specific plans.
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[1] https://fred.stlouisfed.org/series/INTDSRUSM193N
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