With interest rates historically low, many investors are seeking non-traditional means to generate income from their investment portfolios. Often people find comfort in investments that provide interest and dividends because it is based on the rule of thumb that one shouldn’t touch the principal. The financial media has latched on to the subject – it is not hard to find stories on a daily basis on the virtues of income investing.
And that makes me nervous. Investment styles that are currently in vogue tend to attract people that fail to consider the risks. From what I’ve seen, I have the feeling people have a false sense of security. Here are some things that the investor seeking income should consider:
Dividend paying stocks usually go down in value on the date the stockholder is entitled to their dividend. In reality the thought of not touching the principal is an illusion.
Focusing on dividend paying stocks pays no attention to dividend paying stocks of the future. Great companies usually do not initially pay dividends. Only when their business matures and growth slows do they begin these payouts.
There is no documented research that proves dividend-paying stocks weather downturns in the stock market better than non-dividend paying stocks.
Only 40% of the domestic stock universe pays dividends and a majority of these stocks fall in only a handful of business sectors. You are giving up a lot of diversification.
If a bond or bond fund is carrying a higher yield, there is a reason for that – it’s called risk. Bonds that have longer maturities are more likely to fall in value when interest rates go up. Some bonds have higher risk of default. Other investment vehicles such as closed end funds borrow money at lower rates to buy higher yielding bonds. Some bonds go overseas and are subject to currency or sovereign debt risk. Municipalities can fail as well – all you have to do is look at the credit default swap rates of municipal bond insurers to see the risk is real. There is no free lunch here.
How bad can it get if interest rates were to rise? If we have a sudden 2% jump in interest rates within a 12 month period, I estimate an owner of a 20 Year U.S. Treasury Bond will see the value of the bond go down by about 18%.
If and when interest rates should rise, I fear the same herd of people flooding in will turn the other way and may cause a mass capitulation. If these yields begin to look lousy as compared to prevailing interest rates, people may hit the exits all at once and we could have an acute decline in these types of securities.
Capital gains are more tax efficient. When one sells a security, some of the gains come back as cost basis and is not taxable. All of a dividend or interest payment is taxable. Also you control when to take a capital gain while you have no control on when to receive a dividend or interest payment.
In the end, dividends and interest shouldn’t be shunned. I only fear that investors have placed too much myopia on the subject than is warranted. Rather than income, seeking a total return approach which include capital gains will not only provide better after tax returns over the long haul, but it will do this with a lot less risk. We’ve gone through a secular bull market for income investors for over thirty years. If and when the secular cycle ends, I fear that many people will be in for a rude awakening.