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Still a Good Market for Finding High Income Without High Risk

April 10, 2012 | About:

Bonds have been in a seller’s market since late 2009 and with rare exceptions, they’re a poor place to put your money now. If you’re investing for income, dividend-paying stocks are your only real choice.

The ability to issue 30-year bonds at little more than 4 percent interest is extremely bullish for companies’ growth, but it leaves bond buyers with meager returns.

Meanwhile, bond yields have rarely been this low for long. A rise to more normal levels, say 5 percent to 6 percent, would take a huge bite out of principal. Losses would be catastrophic for many bond funds, because they commonly employ massive leverage to pay higher yields than the bonds they hold.

Dividend-paying stocks aren’t the bargains they were in early 2009, or even last autumn. However, strong companies from a wide range of industries still yield 5 percent to 7 percent — and they’re consistently growing those payouts every year, sometimes every quarter.

Consistently growing dividends are a sign of financial strength, of a real business making real profits. Dividend-paying stocks’ prices will follow a rising payout higher over time, increasing capital gains.

There’s no one perfect sector or stock. Every choice carries dividend risk and is vulnerable to overvaluation as well. The key to successful dividend investing is to diversify and maintain a rough balance among different companies and sectors. That way no one stock can sink your portfolio if its shares stumble in these times of uneven economic growth and uncertain global credit markets.

Dividend-paying stocks will only maximize yield, dividend growth and capital gains if you buy and hold. As I told readers in my Investing Daily article, Dividend-Paying Stocks and Riding Rough Seasthat means living with both inflation and credit risk.

Conventional wisdom is that dividend-paying stocks always sell off when interest rates rise. The opposite has been true, since the end of 2007.

The yield on 10-year US Treasury notes — the benchmark rate for all income investments — has plunged sharply three times since 2007, as safety-seeking investors fled to the only global market large enough to accommodate them.

The first was during the crash of 2008; the second in 2010 in the wake of worries about European credit; and the third in 2011, during the market panic following S&P’s downgrade of U.S. government debt. However, each time Treasury bonds soared — and rates fell — dividend-paying stocks crashed across the board. Conversely, when the panic subsided and Treasury bonds sold off, stocks rallied hard. These developments were clearly predicated on the economy, not interest rates.

Rising rates hurt dividend-paying stocks by boosting borrowing costs. The most vulnerable are companies with hefty immediate refinancing needs. The good news is after two-and-a-half years of rock-bottom borrowing costs, only the weakest haven’t been able to shore up their balance sheets.

Higher borrowing costs make it more difficult to grow, particularly in capital-intensive industries. That’s not happening yet, as corporate borrowing rates remain very low and only basket cases — such as bankruptcy candidate Sprint Nextel (S)—are paying up to issue bonds.

The real lesson of 2008 is that no matter how bad conditions get, inherently sound dividend-paying stocks inevitably recover, provided they hold their dividends, maintain balance sheet strength and keep plans for growth on track.

About the author:

Investing Daily provides stock market advice and investment newsletters to help independent investors achieve a secure and rewarding financial future. The site’s coverage focuses on finding the most profitable emerging trends in the investment universe to bring investors pragmatic and in-depth coverage of the names that are taking advantage of these opportunities.

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