With rock-bottom interest rates unlikely to rise anytime soon and some stalwart companies cutting dividends, being an income-oriented investor has become that much more challenging.
Challenging, yes, but not impossible. Both fixed-income vehicles and dividend-paying stocks still have their roles in income-investors’ portfolios, but advisors say how to use these instruments requires thought and perhaps more due diligence in the current economic climate.
The Role of Bonds
Federal Reserve Chairman Jerome Powell said in June that the central bank is “not even thinking about raising rates,” which means fixed-income investors need to revisit how to use bonds in their portfolio.
Traditionally, bonds performed three roles in a diversified portfolio: income generation, low volatility and as a hedge against stocks, says James West, CEO of Principal Street Partners.
With the U.S. 10-year Treasury note under 1 percent and unlikely to rise anytime soon, bonds’ role as an income generator is all but gone, he says.
“For investors who were invested in bonds prior to the downturn, you have some of those higher-coupon bonds,” West says. “You definitely want to hold on to them because they’ll protect you better if rates go up.”
Bonds can still temper market volatility, although he says that role has been diminished somewhat. “If we do get rising interest rates, that volatility is going to increase,” he explains.
Despite bonds’ first two roles now less important, they are still a hedge against stocks, as seen in their first-quarter outperformance. Even with historically low rates, West says tax-exempt areas, such as in the municipal high-yield sector and short-duration muni bonds, remain attractive.
Steve Azoury, financial advisor and owner of Azoury Financial, says he still uses bond funds for income investors, but he diversifies holdings. He employs a mix of U.S. government, corporate, high-yield and global bonds. He spreads out holdings evenly across the sectors in a traditional 60 – 40 percent stocks-to-bonds portfolio. When considering bonds, he says, investors need to think about total return and not just income, as total return has been a significant driver of bond performance lately.
Revisiting Dividend Investing
Buying dividend-payer stocks has been an academically sound strategy for investors for decades, and in the era of low interest rates, dividend investing is a popular way to boost yield. However, even this strategy has come under strain due to the coronavirus.
The recession caused by the global economy shutting down to fight the virus hit certain sectors hard, such as energy and travel. Some favorite dividend-paying stocks for income investors include energy giants like Occidental Petroleum (OXY) and Royal Dutch Shell (RDS.A, RDS.B), whose share prices plummeted when oil prices cratered, causing them to slash dividend payments.
“The energy sector’s losses are really going to be staggering, and it’s going to take years to come back,” says Azoury. “Those dividends aren’t coming back. You’re not going to get the growth, and if you’re not going to get the dividends, then you really have to leave that sector.”
A number of energy-sector companies have cut dividends, but they’re not the only ones. News reports citing a May research note from Goldman Sachs say that 16 percent of the 701 dividend-paying firms in the Russell 1000 cut their distributions.
These distribution cuts are a rude awakening for income investors. And it means a change in how to look at this strategy.
When it comes to dividend investing, West says he uses traditional metrics to analyze companies, but given the unique nature of the coronavirus crisis, he is adding further due diligence. Not only do companies need to have a strong balance sheet and a history of increasing dividends, they can’t be in a sector hit hard by COVID-19. That means he’s avoiding airlines, cinema stocks, cruise ships and other companies that rely on having many people together in contained spaces.
“That’s something new for this environment,” he says.
West is also evaluating companies’ leverage levels compared to industry peers. He is ignoring payout ratios because those are related to earnings “which can be manipulated;” instead he is focusing on cash flow and dividend-coverage ratios. “We feel like that’s more reflective of the company’s ability to pay their dividends,” he says.
Robert Wyrick, managing partner of Post Oak Private Wealth Advisors, says he also looks at coverage ratios when selecting dividend payers, wanting to see that the amount paid is very small relative to the firm’s income stream.
Think Economic Sectors, Not Market Sectors
Wyrick says investors have a habit of looking at market sectors when picking dividend payers; in this environment, he says, buyers are better off focusing on sectors of the economy that are growing.
“If you look at the 11 market sectors, there are probably five or six sectors that generally pay the highest dividends: energy, real estate, utilities, industrials, and unfortunately, those are the ones that are probably the least-attractive from a stability and growth standpoint, in terms of the underlying price value,” he says.
Instead, he says technology, communication services and healthcare are the economic sectors showing the most growth. He admits, though, that healthcare companies pay lower dividends than other firms.
Here, too, total return matters. Wyrick says he’s looking at companies with strong balance sheets whose earnings are growing and show that they are reinvesting in the business, rather than trying to lure investors with the highest dividend possible.
“When you look at the layers of dividend payers, the highest payers usually end up being the weakest companies in terms of balance sheets,” he notes.
The one caveat to dividend investing is that it opens up the portfolio to equity risk. To mitigate that risk, Wyrick says the careful stock selection is important. He notes with the U.S. 10-year Treasury note under 1% and the S&P dividend at 1.85%, income investors do not have to reach very far for yields.
“You don’t have to look too far to actually generate more income than you would in a fixed-income portfolio,” he says, especially with the risk of what may happen to bonds if rates eventually rise.