Where to Seek Equity Income

By Russ Koesterich | July 31, 2014 AAA

During the 25 years prior to 2009, investment income was ridiculously easy to come by. Doing something as simple as buying a 3-month Treasury bill produced an average yield of nearly 5%. That all changed, however, in late 2008, when yields dropped.

Since then, investors looking for income have had to become more creative, and many have looked to equities for income.

But with the bull market now more than 5 years old, you may be wondering whether this approach still makes sense. My answer: Yes, assuming you can take the volatility and look beyond U.S.-focused funds.

To be sure, as I pointed out in a recent post, I’d be wary of seeking income at all costs and ignoring valuation. In other words, asset class cross-dressing, or using stock portfolios to generate income while simultaneously building equity-like exposure in bond portfolios, is becoming risky in some scenarios.

However, there are segments of the dividend space that still look interestin: international and global dividend stocks. Here are two reasons why:

Stocks are still cheaper than bonds. While stocks are no longer cheap, they are cheaper than bonds. One way to measure this – particularly for investors focused on income – is to compare the yield available from a bond fund to the yield available from an equity alternative.

Since 1995, the dividend yield on a broad global benchmark (the MSCI World) has, on average, been 40% of the yield generated from an investment-grade bond index (Moody’s Aaa). Today the ratio is closer to 60%, as the figure below shows.

Chart

While this is below the record of 80% recorded two years ago, it still compares very favorably with the norm. In addition, equities have three additional advantages over bond alternatives: tax treatment favors dividends, stocks have the prospect for future capital gains and stocks can provide a better inflation hedge.

International dividend funds look cheaper than U.S. focused funds. While stocks offer better value than bonds, I would bring up exposure to international and global dividend funds rather than focus exclusively on U.S. dividend funds, which look more expensive. Reflecting this fact, dividend yields in the United States are low compared to the rest of the world. The S&P 500 yields roughly 1.9% versus 3.3% for other developed market stocks (MSCI World ex-USA Index) based on World ex-US and 2.70% for emerging market equities (MSCI Emerging Markets Index).

At less than 2%, the current U.S. dividend yield not only looks relatively low compared to the rest of the world, but it also looks low compared to its own history. And while the yield on U.S. equities is close to its long-term average, the yield on other developed market stocks is nearly 30% higher than the norm.

Still, there’s no getting around the fact that stocks are no longer cheap. Given current valuations, I would expect returns over the next five years to be substantially lower than the previous five.

In addition, investors need to remain mindful of risk. While stocks are cheaper than bonds, equities generally come with more volatility. Today the case for equities as a dividend source comes down to relative value: Stocks are cheaper than bonds while simultaneously providing some upside potential.

The bottom line: For investors looking for income, international and global dividend funds are still a reasonable choice, at least given the alternatives.

Sources: BlackRock, Bloomberg

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

 

 

There is no guarantee that dividends will be paid

 

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries.

 

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