It seems that even student contestants on Fox’s Are you Smarter Than a 5th Grader television game show would know that interest rates are at all time lows. It with is this common knowledge that I assume you are faced with paltry returns on your cash investments, and the low interest rate environment has not been friendly to your current income. Your bond returns may be better, especially if you have been invested in long term government bond funds over the last five years. As interest rates have continued to fall, the returns in this category have been adequate.
From here it may seem like a leap to transition to equity investing, but it is almost a forgone conclusion that interest rates cannot continue this trend, and at some point they will begin to increase. As a result, I will make a case to allocate a portion of your cash and fixed income investments into dividend paying stocks. My objective is to convince you that there is still room in this asset class, even though many individual investors have been flocking into the category and stock prices have become pricy. The increased attention has even swayed some companies such as Apple to offer dividends for the first time, and now 403 of the Standard & Poor’s 500 are paying dividends, the highest level in over ten years.
I will discuss three themes that make a case to be in dividend paying stocks. Market volatility, yield to cost, and the tax cut expirations. I should also mention that this topic has been covered by many analysts and experts, and earlier Dave discussed how to pick good dividend stocks. I also think it is important to mention that investors in this category are generally those searching for current income. This includes current retirees or those near retirement, although there is certainly room for diversification regardless of age or investment philosophy.
Recent market volatility has given investors an opportunity to get into stocks that may have otherwise been expensive. For example, Magellan Midstream Partners (MMP) trades at roughly 21x earnings and is recently down 2.28%; largely on speculation about the impact of the election on domestic oil storage and transportation. However, they increased their dividend payout by 3% during their recent earnings report, and they had already increased their dividend by 12% in the previous quarter. This gives investors an opportunity to improve their yield from 4.25% to 4.52%, or perhaps even better if the share prices falls any further. As noted in the article from Mr. Scott, dividend growth is a key characteristic in picking a dividend stock, and market fluctuations offered additional opportunities to increase yield. I should note that some investors may prefer companies to invest directly in their business instead of increasing their dividend, but Magellan’s business model is consistently generating strong cash flow. This allows them to share profits with their investors in lieu of building large cash reserves on their balance sheet.
Yield to cost is a measurement of what the dividend yield was at the time of purchase. For example, if you bought a company’s share at $100 and the annual dividend was $2.50, your yield to cost is 2.5%. A specific example of how this can work in your favor is to consider Phillip Morris International (PM). If you bought one share at $49.15 in November 2007, the dividend yield was approximately 3.74%. Because of dividend growth over the last five years, the current dividend yield to your original cost is a solid 6.91%. You also get a nice benefit that the stock is up over 79% during the last five years. Again, this highlights that companies who consistently grow their dividends can result in nice income in your portfolio.
The expiration of the Bush-era tax cuts is getting substantial attention in the dividend stock category. This is because the current tax rate on dividend income is 15%, and the maximum rate could jump to as high as 43% after January 1st. However, most reports leave out the fact that many investors use tax deferred investment vehicles such as individual retirement accounts for long-term investing. As such, investors are not taxed until retirement and withdrawals will be taxed as ordinary income, regardless of how the assets appreciated. This eases the potential impact if the tax cuts are indeed allowed to expire.
To be sure, investing in any category requires a risk v. reward analysis. Although bonds have long been considered “safe” investments, investors requiring current income should give thought to hedging against rising interest rates through dividend paying stocks; especially if inflation kicks in and real returns turn further into negative territory.