Income generation is fundamental to a well-diversified portfolio, but achieving a high level of income is increasingly difficult in today’s historically low-interest-rate environment.
At current rates, neither U.S. Treasuries nor investment-grade corporate bonds are capable of generating income that far surpasses inflation expectations. The pandemic drove investors to the safety of Treasuries, which reduced already-depressed yields. Currently, the 10-year Treasury yields approximately 93 basis points.1 At this point, investors can obtain more yield by simply investing in the S&P 500, albeit with more risk.
So, where can investors turn for income? Equities are inherently riskier than bonds, but dedicating a portion of an investor’s equity allocation to a diversified dividend strategy can boost overall portfolio income.
The Benefits Of Dividend Investing
Historically, dividends have played a large role in total market returns, making up 30 percent of the total return generated by the S&P 500 since 1970.2
By leveraging the power of dividend investing, pre-retirees and younger investors can create consistent, recurring income; benefit from capital appreciation and compounded growth; preserve wealth; mitigate volatility; and hedge inflation:
- Monthly income: While most companies pay a quarterly dividend, a diversified portfolio of dividend payers can provide investors with a source of monthly income.
- Capital appreciation: In addition to regular income, investors may enjoy capital gains when the underlying stock price appreciates.
- Compounded growth: By reinvesting dividend payments into new shares, investors can compound returns over time and boost the future income an investor receives. Approximately 78 percent of the total return from 1970 through 2019 can be tied to dividend reinvestment.2
- Dampened volatility: Income payments can also mitigate portfolio volatility. After the dot com bubble popped in the early 2000s, the S&P 500 generated negative total returns, but dividends dampened the drawdown. The price return of the index alone generated -2.72 percent. However, dividends contributed 1.77 percent to returns, bringing the S&P 500’s total return to -0.95 percent for the decade.2
- Inflation hedge: Capital appreciation and income provide a hedge against inflation. Additionally, income increases as companies raise dividends.
It’s worth noting that the role of dividends has varied over time, accounting for a larger portion of the total return for the S&P 500 in years when the total return was below 10 percent.4
The chart above shows the relative power of reinvesting dividends to compound the performance of the market.
Quality Matters
Be wary of high yields. Theoretically, it sounds simple to invest in higher-yielding stocks and hold on for the long term, but in practice, this requires a diversified and research-driven approach to achieve superior results without taking outsized risk. Investors should look for high-quality dividend-paying stocks, as opposed to only considering those that offer high yields.
While high dividend yields may seem attractive at first glance, they can be a reflection of low growth prospects or worse, financial distress. Additionally, high payout ratios, the portion of a company’s earnings paid in the form of dividends, may be unsustainable without coinciding growth in profitability.
Research Affiliates examined the 200 highest-yielding Large Cap U.S. stocks over a 50-year period and found those that ranked more favorably according to profitability and quality measures experienced better average returns with less volatility and a higher subsequent rate of dividend growth. What’s more, the stocks deemed low quality were more likely to default.4
What’s important here is the quality factor: The tendency for higher-quality companies, those that are more profitable and safer, to outperform lower-quality companies. Companies that are more profitable have greater financial flexibility, putting them in a better position to sustain or grow their dividend.
In the chart above, we see that a $10,000 investment in the S&P 500 Quality High Dividend index would have grown to over $107,000, whereas the same investment in the S&P 500 High Dividend index (without the quality consideration) would have increased to approximately $50,000.
For more information related to dividend investing strategies available on the Envestnet platform, please reach out to PMCConsultingSales@Envestnet.com.
Sources:
1. “U.S. 10 Year Treasury,” CNBC, last accessed December 31, 2020, https://www.cnbc.com/quotes/?symbol=US10Y.
2. Morningstar, Bloomberg, QRG Capital Management, Inc.
3. “The Power of Dividends: Past, Present, and Future,” Hartford Funds, last accessed on December 18, 2020, https://www.hartfordfunds.com/market-perspectives/the-power-of-dividends.html.
4. Chris Brightman, Vitali Kalesnik, and Engine Kose, “The Market for “Lemons”: A Lesson for Dividend Investors,” Research Affiliates, last modified in June 2015, https://www.researchaffiliates.com/documents/428-the-market-for-lemons-a-lesson-for-dividend-investors.pdf.
The information, analysis and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.
Investing carries certain risks and there is no assurance that investing in accordance with the strategies mentioned will provide positive performance over any period of time. Investors could lose money if they invest in accordance with the strategies discussed herein. Past performance is not indicative of future results.
For investment professional use only.