The Federal Reserve—with a big helping hand from the global financial crisis and the central banks of much of the rest of the developed world—has turned income investing upside down.
The Fed’s near 0% short-term interest rate target has sent short-term yields for savers and investors plunging toward, you guessed it, 0%. If you scout around you can find market accounts offering 1% or 1.3% tops, but 0.3% or 0.4% is more common. And even that beats the 0.11% yield on three-month Treasury bills as of October 12.
Yields on corporate bonds aren’t any better. Yields on investment- grade U.S. corporate debt fell to a record low 3.56% in the first week of October, according to data from Bank of America.
And now the Fed is making noises—loud noises—about doing the same for long-term interest rates. Yes, the Fed is considering a new round of quantitative easing—a term that doesn’t have anywhere near the shock value of saying “Yes, we’re thinking about buying another $1 trillion or so in Treasury bonds on credit”–to drive long-term rates lower. Lower? A two-year Treasury note already yields just 0.37%. Go out to 10 years and you can get 2.43% on a Treasury. Thirty-years? 3.81%. (Good luck with inflation over three decades.)
Which has made this a completely confusing time for income investors. Investors are looking in every nook and cranny—some of them very unfamiliar and some downright puzzling–to find any extra yield. So in May when Microsoft (MSFT), a company with $40 billion in cash on its balance sheet at the time, moved to sell bonds, investors snapped them up. And why not? The company sold $2 billion of 5-year notes yielding 2.95% and $1 billion of 10-year debt yielding 4.2%. Five- and ten-year Treasuries currently yield 1.12% and 2.43%, respectively.
The reasons that investors have snapped up some other recent debt deals are a little less obvious. In early October Mexico sold $1 billion in 100-year bonds. Now insurance companies and pension funds have a need for long-dated debt so they can match future liabilities with the assets that will pay for them, so I can understand why this deal might have sold. But I don’t, frankly, understand the pricing on this debt. The yield on these 100-year bonds was just 5.8%. Mexican bonds that mature in 2024 yield 6.26%. Give up 0.46 percentage points and take on an extra 86 years of risk? Seems a bit steep just to match liabilities and assets.
But one of the most striking developments in the world of income investing is taking place in a much more familiar sector—telephone stocks. From June 30 to October 13 shares of Verizon (VZ) are up 23%. The Standard & Poor’s 500 hasn’t been standing still during that period but Verizon shares leave the index in the dust. The S&P 500 has gained just 14% in that time.
You don’t have to look very hard to find a reason for the outperformance. Verizon shares pay a huge (for today, anyway) 5.99% yield.
Find that in the Treasury or corporate bond market today?
I’ve had Verizon shares in my Dividend Income Portfolio since October 9, 2009. In that time I’ve seen 10.6% in appreciation and another 6.3% in dividend payouts. And I’m pretty happy with that performance. (To see all ten stocks in my dividend Income portfolio go to http://jubakpicks.com/jubak-dividend-income-portfolio/ )
But the gains over the last three months leave that longer-term performance in the dust too.
What we’ve got now is a roaring bull market in any stock with a reasonably high dividend yield.
And telephone stocks, with their hefty dividends, are one of the biggest beneficiaries. For example, Telkom Indonesia (TLK), another stock in my Dividend Income Portfolio, is up 21% from June 30 to October 13. (My gain since I added the shares to the portfolio on February 2, 2010 is 10.6% plus a dividend payout of 3.4%.
At the moment nothing else matters to investors except the dividend. An analyst can come out and say that a company is operating with almost no room for error—implying that the dividend could be in danger—as Craig Moffett, an analyst at Bernstein Research, did on Verizon on October 12, and set a price target of $25 for a stock then trading at $32 and change, and investors say So what? The stock was down about 1.5% in two days on the call. (A call I disagree with, just so we’re clear.)
Earnings growth can flag. It can even go negative. And right now it doesn’t matter. Wall Street projects earnings growth for Verizon at a negative 7.7% in 2010 and a piddling (but positive) 3.93% in 2011. For five years the projected annual growth rate is just 4.3%.
It doesn’t matter to investors now. All that matters is that almost 6% yield.
Of course, at some point that growth or lack thereof will matter. Someday investors will say, Well, a dividend of 4% (assuming continued stock price appreciation) isn’t enough. And besides Treasury yields have climbed with the return of inflation and the need to get overseas investors to keep buying U.S. Treasuries so we can fund our $21 trillion national debt (It’s $14 trillion at the moment according to the U.S. debt clock (http://www.usdebtclock.org/ ).
At that moment, I don’t think you want own a stock with a negative earnings growth rate or even a miniscule positive growth rate. (Of course, by that point, in my opinion, Verizon’s massive current investment in building out its infrastructure will have started to pay off.)
When does that moment arrive? Not for a while yet. The Federal Reserve is almost certain to introduce another round of quantitative easing and the buying of $500 billion to $1 trillion in Treasury debt by the central bank is expressly designed to cut long-term interest rates further. I think the dividend stock boom lasts until that program of quantitative easing plays out and the Fed signals that it’s satisfied with U.S. economic growth and ready to start removing some of the trillions in dollars that it has pumped into the economy.
That will start to push interest rates back up and that will end the dividend stock boom.
See that on the horizon in three months? Six? I’d put that moment sometime in the second half of 2011—if quantitative easing works really, really well.
Until then hold onto your high dividend stocks. Collect the yield and smile at the appreciation.
If you don’t own any of that category, it’s not too late to pick up some price appreciation and collect a decent dividend. The Fed is going to drive down longer-term interest rates some more over the next three to six months. And that will help these stocks.
You can find some candidates in my Dividend Income Portfolio. A few other names to look at for this play include AT&T (T) with its 5.92% yield, Royal KPN (KKPNY) with its 4.53% yield, and Philippine Long Distance Phone (PHI) with its 5.71% yield.
Full disclosure: I don’t own shares of any company mentioned in this post in my personal portfolio.