Given the current state of cash interest rate yields, there is a strong case for investing in bonds and dividend-paying stocks.
Looking to dividend-paying stocks in the near term is a good idea because you are getting attractively compensated in a reasonably high-quality portfolio of companies. The aggressive rate recalibration by the Federal Reserve since September, combined with a reduced likelihood of a recession, recently put upward pressure on interest rates.
This has created an attractive entry point opportunity for investors considering increasing their allocation to dividend-paying stocks. With stock valuations at robust levels, dividend growth (and earnings growth) may prove to be a significant factor in future returns from the stock category.
Dividend-paying stocks, similar to bonds, benefit from declining interest rates. As interest rates decline, the yields on fixed-income investments like bonds fall, making stocks' dividend yields comparatively more attractive. Lower interest rates generally lead to improved valuations for dividend stocks. Lower interest rates also can reduce a company's borrowing costs, potentially leading to increased ability to pay dividends and profitability.
Broadly speaking, dividend investing strategies fall into two categories. High dividend-yield strategies target companies with high dividend yields. These strategies generally have the potential to offer primarily a high level of dividend income and, secondarily, the opportunity for capital appreciation.
Dividend growth strategies, the second category of dividend stocks, focus on investing in companies with a history of consistently growing their dividends. The ability to grow dividends consistently over long periods may be a good indicator of fiscal discipline and capital allocation within a company. These stocks provide the potential opportunity to benefit from dividend income as well as capital appreciation.
Dividend-yielding stocks also tend to benefit from lower interest rates because lower interest rates may be supportive of stock valuations as a whole. Dividends are not guaranteed and can be cut - so it is good to look for companies that have steadily been increasing their dividends over time, as that is a good measure of the health and sustainability of the dividend payment.
Sectors like utilities, consumer staples, REITs, communication services, and financials become more attractive, as they often offer dividend yields in the 3-5%+ range. Dividend-paying stocks also tend to have strong balance sheets and consistent cash flows, which are attractive characteristics in an uncertain economic environment. Profits earned by dividend payments can help reduce losses if stock prices decline, which may help investors reduce volatility and risk within investment portfolios.
Dividend yield, dividend payout ratio, and dividend growth rate should all be considered when evaluating investments. These metrics should be used in conjunction with a broader analysis of the company's overall financial health, valuation, management team, business model, and industry trends. It's also important to compare these ratios against industry benchmarks and historical performance. There are a lot of diversified ETFs that focus on companies that pay dividends (and grow dividends) over time. This is a great way to get diversification from a basket of companies that pay dividends.
Companies that pay higher than average dividend payments are also considered a tax-efficient source of income. That’s because payments provided by qualified dividends are taxed at significantly lower rates than income earned from other sources. Many investors view a company’s ability to pay dividends as a better indicator of a company’s growth and profitability than changes in a company’s stock price. This can help dividend stocks retain more value and limit an investor’s downside during future economic downturns.
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David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (www.whartonwealthplanning.com). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.