The U.S. Federal Reserve has announced that it would keep interest rates near record lows until at least 2014. With interest rates at rock bottom levels, dividend stocks offer investors an alternative bond-like instrument with a much higher yield. In this article, we'll look at why this trend exists, how to select the best dividend stocks and several key risks to keep in mind.
SEE: What Investors Should Know About Interest Rates
Interest Rates 101
Interest rates are simply the cost of using someone else's money. Many consumers are familiar with the term via the real estate market. Homebuyers borrow money from a bank (in the form of a mortgage) and must pay the bank a certain percentage on top of their principal payments in exchange for the privilege of borrowing the money in the first place.
When it comes to the financial markets, the term "interest rate" often refers to the U.S. Federal Reserve's federal funds rate. Commercial banks pay this rate to borrow money from the U.S. Federal Reserve, which is ultimately responsible for maintaining the money supply. Higher interest rates discourage borrowing, while lower interest rates encourage it.
Interest rates, therefore, have a large impact on the stock market. Lower interest rates encourage higher stock prices, since investors tend to move out of low-paying government bonds and into riskier securities. Low interest rates also encourage lending and therefore tend to increase economic activity, which also bodes well for many publicly traded companies.
Dividend Stocks Outperform
Dividend stocks tend to outperform the overall market in low interest rate environments. There are many reasons for this trend, including:
- Flight to Safety - Low interest rates generally coincide with poor economic health (since they are used to stimulate the economy), which is the same time many investors are seeking safer returns in blue chip or dividend paying stocks.
- Bond Alternatives - Low interest rates make U.S. bonds relatively unattractive, which encourages investors to move into other asset classes, like equities. Many investors may seek bond-like equities, such as dividend stocks, that offer an income.
An example of this outperformance can be seen when comparing the S&P 500 to the Vanguard Dividend Appreciation ETF. Between December of 2007 and June of 2009, the latter outperformed the S&P 500 index by more than 6%. It's important to keep in mind that Vanguard includes a management fee, has less volatility and has a lower P/E ratio.
An older study conducted by InsiderMonkey found that, between May 1938 and October 1950, when interest rates were below 2.5%, high dividend stocks returned an average of 18.1% (including dividends), compared to value-weighted market returns (including dividends) of just 12.7%. In other words, dividend stocks outperformed the market by 5.4% per year on average.
Finding the Best Dividend Stocks
Any financial advisor will tell you that choosing investments depends on a person's individual situation. While the same is true in this case, there are several methods that can be used to select dividend stocks that have a lower risk and higher likelihood of continuing to pay dividends to investors. Always remember, there's more to buying a dividend stock than the yield. Here are some common criteria to keep in mind:
- Beta Coefficients
Beta coefficients measure a stock's volatility relative to the S&P 500 and represent a great way to gauge risk. Those looking for safer dividend stocks should seek out those with a beta coefficient of less than 1.0.
- Free Cash Flow
Cash flow is the lifeblood of every public company and it's very important in determining if a company can continue to pay dividends. Investors should look at free cash flow figures in 10-Q or 10-K filings, especially for stocks paying a dividend that seems higher than normal, to make sure they can afford it.
- History of Payment
Companies that have paid dividends consistently over time are more likely to continue paying dividends, whereas those with a short history may be tempted to reduce their dividend at the first sign of trouble. Investors should look at these historical payments and seek out companies with long track records.
- Consider Blue Chips
Investors seeking U.S. bond alternatives may want to seek out stable blue chip stocks with steady dividends. Larger companies have a lower likelihood of going out of business, while their volatility also tends to be less than smaller stocks.
Risks to Consider
Despite the favorable economic environment for dividend stocks, there are several key risks that investors should consider before committing capital, including tax rate risk. Dividend tax rates for qualified dividends are, as of March 2012, capped at 15%, but new budget proposals from the U.S. government could increase those figures. In fact, dividend taxes could be increased to ordinary income rates for couples earning $250,000 or more and singles earning $200,000 or more.
Dividend stocks carry the same risks as traditional stocks, which are typically greater than U.S. government bonds or other debt securities. Stocks can more easily experience a loss in value, as well as decide to lower or eliminate their dividend yields with little notice.
The Bottom Line
Dividend stocks tend to outperform the overall market during low interest rate environments for a number of different reasons as listed above, as well as serve as good investments for people seeking companies with strong fundamentals. However, it's important that investors carefully select the dividend stocks that they invest in, while keeping the risks in mind.