By Carla Fried
After kissing 3% at the start of the year, the yield on the 10-year Treasury is down nearly a half a percentage point. Investors with a core bond allocation tied to the Barclay’s Aggregate Bond Index aren’t exactly raking in income either, as the iShares Core Total US Bond ETF (NYSEARCA:AGG) has a trailing 12 month payout of 2.2%. Meanwhile, diving into the junk pool means accepting record-low reward for what can be a very risky investment.
US High Yield Master II Effective Yield data by YCharts
Think that 5% yield is just fine given inflation is running at less than 2%? Okay, but let’s not forget the risk side of the equation: Here’s how the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) fared during the financial crisis:
JNK Total Return Price data by YCharts
That’s not to suggest that the next market downturn would be of such epic proportions, but rather to illustrate the inherent volatility of junk bonds during recessions/market stress. As the above chart shows, junk starts to look a whole lot like stocks in bad weather.
Which raises a question: What would you rather own right now? Junk bonds with 4%-5% yields that pack plenty of downside risk, or the stock of high quality companies with dividend yields of 3%-4% or so? Yes, the stock yields are lower than what junk pays, but junk is very pricey today—as witnessed by the record low yield -- while there are plenty of high yield stocks trading at fair, if not, undervalued levels.
Two years ago, income seekers ready to venture out of bonds and cash flocked into AT&T (NYSE:T) given its fat yield. That yield love pushed the price ever higher even while AT&T earnings didn’t keep pace. After a steep valuation run-up, AT&T’s PE ratio has floated back down to a level that makes for a much saner entry point to grab its 5%+ yield.
T PE Ratio (TTM) data by YCharts
As noted recently at YCharts, AT&T’s current payout ratio leaves room to continue its conservative dividend growth path, and if it does indeed scoop up DirecTV (DTV) that would add a few more billion in free cash flow that could conceivably find its way back to shareholders in a better-than-expected dividend flow.
Over in utilities, the other high yield/slow-dividend growth sector, PG&E (NYSE:PCG), Consolidated Edison (NYSE:ED) and Southern (NYSE:SO) all yield more than 4%. As the chart below shows, Southern seems to have the goldilocks dividend payout history: a steady run of annual increases well above inflation.
PCG Dividend data by YCharts
If you’re not beholden to SRI, tobacco stocks are another place to find 4%+ yields from the likes of Philip Morris (NYSE:PM), Altria Group (NYSE:MO) and Reynolds American (NYSE:RAI). Altria and Philip Morris both have impressive operating margins:
MO Operating Margin (TTM) data by YCharts
On valuation there’s not much separating those two, though Philip Morris has the incrementally lower trailing PE ratio:
MO EV to EBITDA (TTM) data by YCharts
Morningstar (NASDAQ:MORN) rates both Altria and Philip Morris as wide moat stocks. Altria currently trades right at Morningstar’s estimate of fair value. Philip Morris is at a slight 5% discount to fair value.
Pfizer (NYSE:PFE) has a current dividend yield of 3.6%. If it eventually succeeds in twisting AstraZeneca’s (NYSE:AZN) arm into a merger, a chunk of the billions of offshore earnings now sitting in cash could be unleashed, ostensibly some of it finding its way into dividend boosts.
Chevron (NYSE:CVX) presents perhaps the strongest risk reward profile for income investors looking at stocks. Chevron’s near 3.5% dividend yield is nearly one percentage point above the 10-year Treasury rate, and is almost double the overall yield for the S&P 500. Chevron’s current yield is also 1.3 percentage points more than what investors hugging the Barclays U.S. Aggregate bond index have pocketed over the past year.
Though Chevron’s valuation has moved up since its early 2012 low, we’re still talking about a PE ratio below 12 once its prodigious cash is backed out, which makes it even cheaper than Exxon Mobil (NYSE:XOM):
CVX Price to Earnings Less Cash (TTM) data by YCharts