These days, fixed income investors have a lot of choice when it comes to getting the yield they need. Thanks to the recent bond crash and the Fed’s interest rate increases, the bond market has sort of been reset. Everything from cash and T-bills to junk bonds and preferred stock is now paying close to historic norms when it comes to yield. This includes some bond substitutes and complements.
In this case, we’re talking about dividend stocks.
As investors have rushed to the safety of bonds for their higher yields, dividend stocks have been thrown to the wayside. However, with yields high and some unique benefits, equity income can actually make for a great partner with fixed income investments. And now, with the recent stock market declines, investors may have a chance to load up on dividend stocks on the cheap.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Bonds Fell, But So Did Stocks
The rallying cry of the last decade or so has been, “There is no other alternative.” With the Federal Reserve keeping interest rates at effectively zero for the better portion of a decade, fixed income investors were thrown for a loop. If you wanted any sort of return, you had to invest in stocks. That strategy worked well until inflation surged and the Fed was forced to raise interest rates.
Now, there are a lot of other alternatives.
With money market funds paying 4.4%, T-bills paying close to 5%, and even investment-grade corporate bonds paying close to 6% in interest, investors have been mixed on stocks. Why take the risk in equities when you could have the safety and security of earning a good return in bonds or cash? This preference continues to show up in returns for the broader market.
All in all, the one-year return for the S&P 500 is a negative 8.72%. Looking at just 2022, the bread & butter stock index sank by a whopping 19.64% for one of the worst returns in recent history.
As expected, high growth names were some of the worst performers in that negative return. However, one of the more interesting takes has been investors abandoning dividend and equity income-focused stocks. Investors have continued to abandon dividend names in the new year. According to Refinitiv Lipper, investors pulled more than $1.5 billion out of dividend-focused funds last week. This is the largest negative asset flow of the category since December 2021 and was the fourth consecutive week of outflows from the segment.
A Potential Opportunity
With cash and other assets now yielding more, it’s easy to see why investors have abandoned equity income and dividend stocks. However, they may want to rethink that stance. And the current outflow could make for a great buying opportunity.
Equity income can work in concert with bond investments to provide a strong inflation-protected base of income. The key to that fact is dividend growth.
One of the problems with bond investments is that coupon rates are fixed. And while rising interest rates do push up short-term yields, those increases are often below the annual pace of the CPI and other measures of inflation. Dividend-paying stocks, however, have historically been able to provide dividend growth at rates in excess of the CPI. Since the 1990s, stocks in the S&P 500 have managed to raise their dividends by an average of 6.58% per year. The long-term average rate of inflation for the United States has been about 2.29% since 1900. Looking at last year, when inflation spiked to levels not seen since the 1980s, dividends managed to grow by 10.07%. This beat inflation by over 1.1 percentage points.
This fact alone makes adding equity income to a fixed income portfolio a necessity.
Second, equity income can provide ballast just like bonds. Getting 2% to 4% per year in cash can help limit losses and dividend stocks are often less volatile than non-dividend-paying firms in the first place. In fact, dividend growth stocks held up better than both bonds and the broader market last year. The Morningstar US Dividend Growth Index only lost 7.85% in 2022. That’s better than the broader bond market’s 13% loss.
And right now could be a wonderful time to add the sector. Dividend stocks in the S&P 500 currently offer a yield in excess of 2.58% and can be had for less than the broader market on a forward P/E basis.
Adding Equity Income to Your Fixed Income Portfolio
Given that dividend rates have historically grown faster than inflation and that dividend stocks have been good ballast, fixed income investors shouldn’t be so quick to abandon stocks. All in all, they can provide a great complement to bonds and help grow your income over time.
The wonderful thing is that there are numerous ways to add exposure, from mutual funds to ETFs. Simply adding a fund like Vanguard Dividend Appreciation Index Fund ETF (VIG) or Fidelity Equity-Income Fund (FEQIX) could be all you need. However, here at Dividend.com, we have all sorts of tools to help you build a portfolio of individual dividend stocks.
Ultimately, investors may not want to run completely away from dividend stocks. They offer some benefits that match perfectly with bonds.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
