The Siren Song of Selling Bonds to Buy Dividend Stocks

Interest rates currently remain near all-time lows. Recently, clients have been inquiring about selling lower-yielding bonds & purchasing higher-yielding dividend-paying stocks instead. This article will debunk the myth that dividend-paying stocks are less risky than other stocks and will explain our thinking about why investors should probably avoid the siren song of high dividend stocks, even though bond yields are low.

The Investment Objectives of Fixed Income

When our client centric team meets with a client to develop their Wealth Management Plan, they pay particular attention to the client’s willingness and ability to bear risk. Striking the right balance between growth and safety is critical. The best way to generate growth in a portfolio has been to own stocks. The best way to limit risk has been to own bonds.

The primary objectives of allocating assets to bonds and fixed income are:

• capital preservation,
• income generation, and
• volatility reduction.

While dividend-paying stocks accomplish income generation, they fail on the objectives of capital preservation & volatility reduction.

Does it Matter What Type of Dividend-Paying Stocks?

A well-known problem of investing in the highest-yielding stocks is that they are risky. The price is low relative to the historical dividend because the company is in some sort of trouble. Often, the dividend may be cut in the future to preserve cash. As a result, various approaches have developed to adjust for the riskiness of the dividend-paying stocks. Among the types of investment preferences are:

• The highest yielding stocks,
• Stocks that have been paying and growing dividends (known as Dividend Aristocrats),
• High quality dividend stocks (dividend-paying stocks with lower debt levels),
• Low volatility, high dividend stocks (dividend paying stocks with lower price volatility)

We will consider each of these approaches in this article. However, you will notice that these various adjustments do not alter our conclusion. Regardless of the approach, owning dividend-paying stocks fails on the investment objectives of capital preservation & volatility reduction.

Capital Preservation

Who needs capital preservation? If you have 30 years to invest and no demand on capital (no need to support spending with your portfolio), your portfolio can emphasize growth and eschew capital preservation. Most investors, however, use their investment portfolio to support their standard of living in retirement.

As investment horizons shorten, and as demand on capital rises, investors have a greater need for capital preservation. One way to measure capital preservation is to look at drawdowns (meaning the total peak-to-trough loss when the market goes down).

Historical data 12/31/1994-Present; Source: Bloomberg

As is clear from the data, dividend-paying stocks have had drawdowns similar to the broader stock market, 50-70%, and have had multi-year periods where values have been below historical highs, in particular after the global financial crisis in 2008. This compares with our core bond index, where the worst drawdown was 4% and lasted a little more than a year.

Funding living expenses during these drawdown periods can be challenging. Take, for example, a hypothetical retiree with a $2 million portfolio funding monthly expenses of $8,000 (growing at 2% inflation). Assume they own 60% in the S&P 500 index and 40% in either bonds, or dividend-paying stocks. For someone retiring 12/31/2000 or 12/31/2006, dividend-paying stocks would have increased the risk, but would not have provided a benefit over bonds for quite a while into their retirement, if at all.

A portfolio with 40% bonds, meanwhile, provided meaningful protection to these hypothetical retirees, in each case protecting at least $250,000 of the portfolio’s value:

The portfolios featuring simply the highest yielding stocks (HiDiv) in place of bonds actually fell so much that they have struggled to fund spending needs and grow back to the original $2 million. This demonstrates the benefits of holding diversifying assets, and the risks of not doing so, when there is a demand on capital.

Volatility Reduction

This example also demonstrates that bonds provide meaningful diversification in a balanced portfolio. But, could dividend-paying stocks deliver similar results when incorporated in place of bonds?

No. Dividend-paying stocks are highly correlated to the broader stock market (.77-.87). As a result, incorporating them into a blended portfolio does not meaningfully reduce volatility.

Incorporating bonds, on the other hand, reduced volatility by 40% and still delivered 88% of the return of owning only the S&P 500 over the period 12/31/94 – 3/31/21. That is due to bonds having a negative correlation with stocks. Bonds have proven to be good diversifiers of equity risk.

How to Think About Dividend-Paying Stocks

So, we have shown that dividend-paying stocks are not less-risky than other types of stocks. Incorporating them into a blended portfolio also does not reduce risk. As a result, we think dividend-paying stocks should simply be compared to other types of stocks, not to bonds.

At the moment, we do not see a compelling reason to be overweight dividend-paying stocks within our global equity portfolios. Why? Well, the decision to pay dividends is simply a corporate financing decision. It can be a sign of a stable company, but not always.

Increasingly, dividends are a less popular way of returning cash to shareholders compared with share buybacks. For example, over the last 3 years, Apple has paid $41.9bn in dividends. Over that same time, they repurchased $209.7bn in stock, five times more than the dividend payments. Investors simply evaluating stocks based on the dividend yield would have missed that Apple, and other companies like it, are returning a lot of capital to shareholders through buybacks.

Another dynamic to consider is that if companies have profitable growth opportunities, as an investor, you actually do not want them to pay a dividend! Instead, you want them to invest their profits back into the business to grow. This has been the case with Amazon, for example. Amazon has not paid dividends nor has it repurchased shares. Instead, it has reinvested about $178bn back into its business in the form of Research & Development ($107.5bn) and Capital Expenditures ($70.4bn) over the past 3 years. As a result, analysts are forecasting Amazon’s revenue to grow from $386bn in 2020 to $558bn in 2022. Clearly, investing in Amazon has been a great investment despite the lack of a dividend.

Finally, dividends are simply a payout from earnings & cash flows. When our analysts evaluate stocks, they focus on the company’s ability to generate sustainable cash flows. Investors that focus too narrowly on dividends can wind up invested in stocks that provide dividends, but lose market cap. This has been the case with Exxon Mobil, for example. Since 12/31/2007, Exxon has paid $147bn in dividends to shareholders, but has lost $268bn in market cap, dramatically underperforming the market.

Conclusion

Although we understand the temptation to reach for yield in dividend-paying stocks, we do not recommend it. Dividend-paying stocks carry all the risks inherent in stock market investing without the risk-reducing benefits of bonds. In addition, we believe investing in a stock on the simple basis of its corporate financing decisions is unwise. Instead, our analysts attempt to understand the full picture of a company’s ability to generate cash flows and deploy those cash flows, whether in the form of dividends, share repurchases, research & development, or capital expenditures, to provide the best total return to shareholders. Thank you for your consideration. If you would like to discuss these ideas further, please reach out to a member of your client centric team.