Buying Bonds with Coupons that Grow

by: Fred Fraenkel

High yield stocks are dull and defensive and have certainly been out of favor in a year characterized by one of the strongest rallies off the bottom in stock market history. We’ve pushed stock investing outside of the United States and have pointed out that we believe bond yields will rise over the next several years. Against a backdrop of great performance in the stock market since March, many market watchers are starting to rediscover stock with high dividend yields. Barron’s wrote a cover story on this topic this week.

If bond yields go up, the normal argument would be that you should stay away from high dividend yield stocks because higher bond rates is more competition for stocks purchased to capture a high dividend. This logic may be right at certain times in a market cycle, but it’s not right now. It seemed right on Friday, when utilities took a hit as bond yields spiked.

However, when you look at where dividend yields are on companies that can be counted on to grow their dividends over the next several years and compare them to bond yields which are still at very low levels; it becomes obvious that income investors can still capture tremendous opportunities at current prices on dividend yield stocks. The companies (not including AES) that make up the Dow Jones Utility average currently yield 4.5%. That’s just about exactly 1% more than a U.S. Ten Year Bond. The dividends you receive from this group of companies will most certainly increase over the next ten years. The income you receive from the ten-year is fixed.

Investors became so scared of stocks during 2008 and the first quarter of 2009 that they sold off all financial assets to very low prices. As the world adjusted to a non-depression scenario many asset prices melted up. Stock prices have rocketed off the bottom.

High yield stocks, which are defensive by nature, have gone up less than many other types of stocks. However, as investors who maintained large cash positions become more comfortable that the world is not ending they are moving out the yield curve to capture some income. Some income is better than the “no income” which cash instruments provide. Cash investors limping back to risk to capture income explains why the two year is yielding less than 1%. Certainly investors, in aggregate, can’t believe that a less than 1% yield is a good real return for holding something two years.

However, Friday’s bond action does show that there is interest rate risk up and down the yield curve. Bonds really have to be short maturity to protect investors against the interest rate risk associated with recovery fundamentals. Holding short maturity bonds at this point, however, generates very little income; therein lays the conundrum. Buying stocks with fat dividend yields is the answer! Even though interest rates will most probably rise over the next few years, this will not prevent these stocks from making progress.

Examining our portfolios at Beacon we find examples of great stocks that have made it through all of our screens and research that provide investors with great current returns that are tax advantaged. Stocks like this that we hold in the various Beacon portfolios include:

Symbol Price Company Current yield
(NYSE:T) $27.60 AT&T Inc 5.90%
(NYSE:BMY) $25.14 Bristol Myers Squibb 4.9
(NYSE:EQY) $16.50 Equity One 7.3
(NYSE:FE) $44.60 First Energy 4.9
(NYSE:NYX) $24.85 NYSE Euronext 4.7
(NASDAQ:MCHP) $27.77 Microchip Technology 4.9
(NYSE:MRK) $36.70 Merck and Company 4.1
(NYSE:RDS.A) $61.14 Royal Dutch Shell 5.3
(NYSE:SE) $19.62 Spectra Energy 5.1
(NYSE:SBS) $37.44 Companhia de Saneamento 4.5
(NYSE:VZ) $32.70 Verizon 5.8

A more normal world will involve having high dividend stocks yielding less than government bonds because they can grow their dividends over time. The opportunity to create a portfolio of stocks that provide good income that can grow is still there, but it won’t be forever.