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.

Related Articles
  1. Credit & Loans

    5 Signs a Reverse Mortgage Is a Bad Idea

    Here are the key situations when you should probably pass on this type of home loan.
  2. Active Trading Fundamentals

    The Top 5 Impact Investing Firms

    Learn what impact investing is and obtain information on some of the top impact investing firms ranked by total assets under management.
  3. Credit & Loans

    5 Signs a Reverse Mortgage Is a Good Idea

    If these five criteria describe your situation, a reverse mortgage might be a good idea for you.
  4. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  5. Investing Basics

    Understanding How Dividends Are Taxed

    Learn how dividends are taxed by the IRS, and understand the different types of dividend income as well as the capital gains tax rates.
  6. Investing Basics

    6 Reasons Why Dividends Should Be Reinvested

    Learn about the advantages of dividend reinvestment programs and how they may benefit longer-term investors who want to build a position in a company.
  7. Options & Futures

    Understanding How Dividends Affect Option Prices

    Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options.
  8. Mutual Funds & ETFs

    4 Mutual Funds to Consider If Interest Rates Rise

    Learn what mutual funds will perform best if interest rates rise. Interest rates can rise due to inflation or to an improving economy.
  9. Credit & Loans

    Guidelines for FHA Reverse Mortgages

    FHA guidelines protect borrowers from major mistakes, prevent lenders from taking advantage of borrowers and encourage lenders to offer reverse mortgages.
  10. Investing News

    China's Government to Stop Intervening in Stock Markets

    China’s stock market, measured by Shanghai Composite Index, lost about 17% of its value in the first three days of week ending August 28, 2015 before recovering its value by 11% in the last two ...
RELATED TERMS
  1. Record Date

    The cut-off date established by a company in order to determine ...
  2. Purchasing Power

    The value of a currency expressed in terms of the amount of goods ...
  3. Monetary Policy

    The actions of a central bank, currency board or other regulatory ...
  4. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  5. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  6. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends ...
RELATED FAQS
  1. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  2. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
  3. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>
  4. How does the stock market react to changes in the Federal Funds Rate?

    The stock market reacts to changes in the federal funds rate in various ways depending on where it is in the business cycle. ... Read Full Answer >>
  5. How do dividend distributions affect additional paid in capital?

    Whether a dividend distribution has any effect on additional paid-in capital depends solely on what type of dividend is issued: ... Read Full Answer >>
  6. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!