Mitigate Inflation’s Impact Via Dividend Growth
Not long ago I wrote about the Series I Treasury Bond as a low-risk way to earn a 9.62% annual interest rate for the next six months. However, as I noted in the article, the actual rate of return over time could differ significantly from that 9.62% headline print.
The potential upside from the bond comes from it being benchmarked to the inflation rate, so the higher inflation goes, the higher the interest rate on that bond. But if inflation is flying high, the rest of your money is losing buying power.
The amount invested into the I bond keeps track with inflation—as measured by the CPI—on a trailing basis, but it’s a limited amount of help because Uncle Sam caps your I-bond purchase at $10,000 per year.
There is no secondary market for the I bond, so you need to directly redeemed the bond for cash from the Treasury Department. If you want to withdraw your money penalty-free, you will need to hold the I bond for five years at a minimum. If you are okay with giving up three months of interest, then you can redeem the bond after one year. But in the meantime, that cash is locked up so it only makes sense to buy the I bond if you won’t need that cash for a while.
Thus, a 9.62% rate on a Treasury bond sounds great, but in practice it’s not for everyone. This is why investors also look for other ways to maximize their income.
Growing Stock Dividend Still the Way to Go
For income-oriented investors who can afford to stay in the market for at least a few years, I think stocks with growing dividends still make the most sense.
High yields, while they look attractive on the surface, aren’t as important as dividend growth and total return.
Let’s say you buy 500 shares of a $20 stock with an 8% yield, this means you can expect to receive $1.60 per share in dividend in the next four quarters (assuming no change to the dividend over that time). That comes out to $800 in annual dividend payment for the $10,000 total investment.
However, if the stock price falls 30% over three years to $14, your overall return, including the $2,400 in dividend received, would be -$600, or -6%.
Note that when a company pays a dividend, the stock price will adjust downward by that amount, so over the three years, $4.80 per share of the stock price decline is attributable to the dividend payout. Adjusted for the dividend payment, the stock fell $1.20 per share over the three years—i.e., 6%.
Yield’s Relationship to Price
Another way to look at a stock yield is how much dividend payment investors demand in order to take on the risk of owning that stock. Holding the dividend constant, the more demand for a stock and the higher the stock price goes, the lower the yield goes. Thus, a falling yield, if the dividend stays the same or goes up, is not a bad thing.
Conversely, a high yield means investors demand a generous dividend payment before they are willing to buy the stock generally due to perceived high risks and/or lack of capital appreciation opportunity. Note that in the case of the hypothetical stock, after three years its yield would rise to 11.4% ($1.60 dividend divided by $14 stock price). But since you are actually losing money overall, that’s not so good.
Therefore, it’s prudent to analyze a high-yield stock carefully before taking the plunge. Moreover, if the dividend isn’t going up, in real terms (adjusted for inflation) that same dividend is losing value over time.
Dividend Growth Mitigates Inflation’s Impact
On the other hand, if you own a stock with a growing dividend, even if the yield is not that high (say, 3%) at the time you buy the time, at least the dividend will grow over time and help to mitigate the erosive impact of inflation.
Of course, if you are in a tax bracket where your capital gains tax rate is much higher than your dividend tax rate, then it’s understandable why you might prefer a high dividend. You will need to do the math for your own situation to see what makes sense.
But regardless of the situation, I can’t emphasize enough the importance of looking at more than a stock’s dividend yield.
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