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76report

March 29, 2024

Talking dividends

Hopefully you received by email or otherwise saw our recent YouTube discussion. For your convenience, we are including it here, along with the slides used in the presentation and a brief summary of the main points.

Among our key messages was the historical long-term benefit of looking to dividend stocks, rather than bonds, as a source of income generation. While it is perhaps well-understood that stocks generally outperform bonds over time, the magnitude of this, and the power of long-term compounding, sometimes gets overlooked.

The chart below compares the relative total return of a High Dividend Stock ETF (VYM) with a Total Bond Market ETF (BND). In retrospect, the opportunity cost of trying to generate income through bonds, rather than stocks, was severe, at least over the past 10 years.

Choosing bonds over dividend stocks didn’t produce any benefit from an income standpoint either. The chart below shows income growth from $10,000 invested in either ETF. This excludes any dividend reinvestment.

A slide that didn’t quite make it into the discussion, but is perhaps worth surfacing now, looks specifically at the relative performance of high dividend stocks (VYM) versus the S&P 500 (SPY) and a long-term Treasury bond ETF (TLT) during the three-year period from the end of 2020 until the end of 2023. We refer to this time frame as the “Inflation Stress Test”—cumulative inflation (as measured by CPI) over these three years was 18%.

A key lesson of the Inflation Stress Test is that, even though they faced headwinds from rising interest rates, dividend stocks performed reasonably well during this period because inflation helped support nominal earnings growth. Interestingly, high dividend stocks performed as well as the S&P 500, with somewhat less volatility.

Meanwhile, long-term Treasury bonds and other long-term “fixed income” instruments fared poorly, precisely because their income streams are fixed. Rising rates mathematically produced lower valuations.

When inflation picked up, long-term government bonds proved to be anything but a “safe” investment. In real terms, an investment in TLT over the three-year period resulted in nearly a 50% loss (combining a -30% nominal return with the 18% decline in the purchasing power of one’s original investment).

While bonds as an asset class have had a rough decade, largely because of the shift in the interest rate environment over the past couple of years, we shared the view that, at this point, long-term government bonds now offer some appeal. The 10-year Treasury currently yields about 4.25%. With long-term inflation expectations around 2.25%, this means the real yield on the 10-year is about 2%, which is significantly higher than pandemic lows, which were around -1%.

Historically, Treasuries perform well when there is a stock market sell-off, which is usually related to some kind of macroeconomic weakness or shock. This was not true in 2022, however, when bonds sold off along with the stock market, as both markets reacted to the sudden shift in interest rates.

But now that most of that resetting of interest rates has probably occurred, it is reasonable to think that long-term government bonds could once again act as a hedge against future stock market weakness. Historically, the beauty of pairing long-term government bonds with stocks is that government bonds rise in value when stocks falter; this sets up a potential opportunity to cash in your government bonds and buy stocks, if and when stocks are down.

Having at least a small strategic allocation to long-term Treasuries, perhaps through an ETF like TLT, now makes sense, in our view. The risk, of course, is that inflation could persist and rates could grind somewhat higher, which would undermine performance. Yields on the 10-year Treasury did touch 5% a few months ago, and investors should always be prepared for that to happen again (or worse).

The area of fixed income that we do not find especially attractive at the moment is credit, such as high yield or “junk” bonds. The bottom part of the graphic above shows the evolution of BB (one notch below investment grade) credit spreads over the same 10-year period.

Credit spreads tend to expand sharply when the stock market sells off, as we saw during the Global Financial Crisis and the pandemic. Credit investors (such as investors in junk bonds) sustain losses when this happens. Today, credit spreads are at historically very tight levels because economic conditions are viewed as benign. These tight spreads may also be related to certain technical factors.

We do not believe investors in credit are being well compensated at this time for potential business cycle risk.

As we returned to the main topic of the video, dividend investing, we contrasted the performance of two Real Estate Investment Trusts (REITS) to make a few points about choosing which dividend stocks to own.

We compared and contrasted Annaly Capital Management (NLY) with Digital Realty Trust (DLR). Income-oriented investors are seemingly always tempted by NLY’s historically double digit dividend yield, which is produced through financial engineering and significant use of leverage.

Rather than chase very high yields, we prefer a “business first” approach to high dividend stocks. DLR, a data center REIT that we have in our Income Builder Model Portfolio, outperformed NLY because its performance was based on a well-positioned underlying business in a structurally growing market.

If you have not seen it, we discuss at length our approach to investing for dividends in a document that we (not so imaginatively) titled Investing for Dividends. In this investment guide, we seek to explain the overall philosophy behind our Income Builder Model Portfolio.

We hope you find the video informative and look forward to producing more of this type of content. If you have any suggestions for discussion topics, please always feel free to email us at trish_and_rob@76research.com.

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