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The Truth about Dividend-Paying Stocks and Interest Rates

By Roger Conrad on March 23, 2012

With all due respect to Wall Street Journal headline writers, it’s far too early to declare a bear market for US Treasury bonds. Yields have crept higher in recent weeks, with the 10-year Treasury note moving as high as 2.4 percent earlier this week before retreating the past couple days.

We saw the same action, however, late October 2011, before the 10-year yield slid once again to the neighborhood of 1.8 percent. And yields are still barely half the level they held as recently as early 2010.

Bear market or no, US Treasury bonds have been a remarkably poor choice for income investors for some time, particularly the longer-dated variety. Not only are yields paltry. But at today’s prices there’s absolutely no margin for error when it comes to inflation or higher interest rates.

Despite downgrades by credit raters, I’m not one who believes there’s any meaningful credit risk in US Treasuries. It’s become fashionable to bash the Federal Reserve’s quantitative easing strategies. And the federal government is certainly running up a lot of red ink, with little indication anyone in Washington is serious enough or even capable of making necessary compromises to close the gap, at least this year.

This doesn’t change the fact, however, that the US Treasury market is still the only place big enough to accommodate safe-haven money in a crisis. We saw that last autumn, as Treasuries rallied to all-time highs. We saw it happen in even greater magnitude in 2008, in the teeth of the worst market crash-credit crunch-recession event in 80 years. And that was in spite of the fact that the origins of both crises were right here in the US.

The only way there is real credit risk to US Treasuries is if Uncle Sam remains in permanent trillion-dollar deficit mode. This is certainly possible. But even in a worst-case, it’s not today’s problem–and therefore not what investors should be focused on now.

Rather, as Treasury holders during the 1960s and ’70s found out, you can lose plenty of money in US government debt even without real credit risk–if inflation and interest rates tick up enough.

At today’s prices there’s absolutely no compensation for taking this risk.

Neither is there adequate compensation for owning corporate bonds, which in many cases yield little more than Treasuries. For example, Duke Energy (NYSE: DUK), Edison International (NYSE: EIX) and Southern Company (NYSE: SO) all issued 30-year bonds at interest rates of barely 4 percent in recent weeks.

That’s low-cost capital to fuel growth and great news for stockholders. But it’s absolutely horrible for anyone looking to buy bonds. As dominant utilities with strong balance sheets, these companies have scarcely more credit risk than Treasuries, at least from a practical standpoint. But a lot can happen in 30 years when it comes to interest rates and inflation.

Even a move back to a 4 percent to 5 percent yield on the 10-year Treasury–a normal level historically–would have a devastating impact on prices of 10-year bonds now yielding 2 to 3 percent. It would likely kick yields on these utility bonds back up toward a more typical 5 to 6 percent, a big loss for anyone buying them now at barely 4 percent.

When you buy individual bonds, you always know what you’re going to get at the end of the road when they mature. That’s the principal, which is usually $1,000. And you also always know what your annual return–the yield to maturity–will be.

The market value of 4 percent a year paid by Southern Company over 30 years will wax and wane depending on interest rates and inflation. But those who just hold their bonds to maturity will always get that 4 percent, so long as Southern is solvent. And that’s a very good bet, possibly even a better one than Uncle Sam.

This assurance most definitely doesn’t apply to the various derivative instruments that purport to be bond investments. These include mortgage REITs, closed-end bond funds and limited partnerships that specialize in holding bonds.

My perennial concern with these is they’re essentially black boxes. You depend on management to run a portfolio well enough to produce the advertised yield. And you have no way of knowing what they’re doing to achieve that yield.

Some of them feature some pretty attractive yields, and many can point to paying them for several years. The problem, however, is that these funds now yield considerably more than the bonds they supposedly own.

We know this not from being able to see what they own in any meaningful way but because of today’s rock-bottom corporate borrowing rates.

It’s still possible to get a yield of 9 percent on a bond. You just have to buy companies like Sprint Nextel (NYSE: S), which is increasingly the focus of bankruptcy rumors due to $10 billion in maturing debt the next five years and $15 billion-plus in iPhone purchase commitments to Apple (NSDQ: AAPL). Or you can go abroad and buy Portuguese government bonds yielding somewhere in the teens.

Other than that you’re talking about bond yields south of 5 percent, and that’s for paper maturing decades hence. That contrasts with yields of 8 percent to 10 percent on the closed-end funds such as PIMCO Strategic Global Government (NYSE: RCS), which has an indicated yield of 8.5 percent.

How do the closed ends do it? PIMCO Strategic Global Government as of Dec. 31 had nearly two-thirds of its portfolio in Fannie Mae collateral securities. It was also heavily levered with a negative cash position of 77 percent.

These are facts I’ll wager not all of their investors know. And I’ll bet even fewer are aware that the fund’s current market price of $11 and change is nearly 10 percent higher than the value of its assets.

PIMCO Strategic Global Government is one of the best of the closed-end bond funds, with a solid long-term track record of navigating some difficult markets. It can’t be denied, however, that its strategies for producing yield now are heavily leveraged to interest rates remaining low.

If this dam ever bursts, management will have to react very quickly to avoid massive losses.

And that has been management’s track record. But there are no guarantees when it comes to such heavy leverage. And other closed-end bond funds sporting today’s big yields have a far less salubrious history of coping with such reversals.

In sum, bondholders should be very worried about the risk of rising interest rates this year. The only exceptions are for low-duration bond funds–the kind that today yield in the 3 percent to 4 percent range–and bonds you’ve owned for a long time with rapidly approaching maturities (five years maximum).

Everything else is highly vulnerable and should be avoided, both for the potential rate risk and the fact that returns are sub-par.

Fortunately, there is a clear alternative: dividend-paying stocks. Credit risk is higher, particularly for the stocks sporting the highest yields. But so is upside as the economy gradually returns to health and companies execute growth plans.

The very safest dividend-paying stocks–regulated electric, gas and water utilities–yield 3 percent to 5 percent. That’s superior to these companies’ long-term debt, and dividends are growing as well. Master limited partnerships (MLP) that own pipelines are virtually as secure as utes, and they offer growing tax advantaged yields as high as 7 percent to 8 percent.

Those worried about the health of the US dollar will do well picking up some shares of top-notch Canadian and Australian companies. These currencies’ US dollar values follow commodity prices, which will have to rise if there’s to be any inflation.

Finally, many US telephone stocks are yielding well over 8 percent, reflecting their out-of-favor status.

One of the greatest fallacies many investors have bought into is that rising interest rates automatically trigger selling of dividend-paying stocks. Reality is that dividend-paying stocks actually follow the prospects for the economy, which are often in near-perfect opposition to rate swings.

We’ve seen this play out over and over again since the crash of 2008. During the debacle itself the yield on the 10-year Treasury note plunged from well over 4 percent to barely 2 percent. This was the same time utilities, MLPs and other income stocks crashed across the board.

Then came the recovery that began in March 2009. Treasury yields soared back to 4 percent, even as dividend-paying stocks surged. The Flash Crash and its aftermath in 2010 saw Treasury yields plunge again, even as dividend-paying stocks sold off. That reversed in late 2010, as Treasuries again moved up to 3.5 percent and the markets rallied. The crisis in Europe sent rates plunging, and dividend-paying stocks again sold off.

That’s about as clear a message as you can get that dividend-paying stocks won’t be doomed if Treasury yields rise in coming months.

In fact, a real up-move in rates is only going to be possible if the US economy shows a lot more life, which, in turn, will spur sales and investment–and, eventually, revenue, earnings and dividends for well-run companies.

Operating a stock portfolio means owning enough companies and being diversified enough so a single company’s stumble won’t sink you. It means being willing to discard a stock if the underlying business backing the yield should weaken. It means periodically rebalancing by taking profits from any stock that grows to be too large a piece of your holdings. And it means being willing to live with volatility, so long as underlying business of a stock is still solid.

Following those simple rules, however, will increase your yields, reduce risk and position you for superior long-term growth in dividends.

And unlike bond investors you’re much more likely to profit when interest rates rise than lose money.

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  1. avatar
    Dave Birtwell Reply March 25, 2012 at 7:32 PM EDT

    Roger: I’ve been enjoying Utility Forecaster for years now, always renewing for three year intervals due to deteriorating health. Just renewed my subscription to UF again and signed-up for Big Yield Investing, which I love, too. I always wanted to make a living by investing in stocks! Now I’m at it, as I had to resign the job I had for 7 years on 022012. Is it possible to receive The Big Switch for already renewing UF for 3 years and signing-up for High Yield Investing? I think you and T. Boone Pickens are correct. I also hope to live long enough to see our vehicles powered by natural gas. I did receive Powering China and Liquid Gold Rush for renewing UF. And hope to make some money to sign-up for your new Australian newsletter. Thank you again for all you do for your UF subscribers. Dave

  2. avatar
    TNflash Reply March 24, 2012 at 9:54 PM EDT

    Very well written article with excellent advice. I would like to see more like these.

  3. avatar
    lou sayland Reply March 24, 2012 at 2:42 PM EDT

    grt. article and i agree 100% – i started dividend investing 2 yrs ago and have a steady stream of income in my retired yrs. i do not seek out hugh yielders and am comfortable with 4 to 7/8 % return. the great majority of my 25 +/- stocks have appriciated, dividend investing & reinvesting dividends has proven to be proven good over many yrs. thanks, lou