Dividend Growth Vs. Fixed Income Challenge: Can You Grow Dividends On Fixed Income?

|
 |  Includes: FGE, NEE
by: Five Plus Investor

I’m sorry, but your grandmother got it all wrong.

No, I’m not trying to pick a fight. I’m sure your grandmother was a real swell lady. Instead I’m challenging a truism we all heard growing up, which is – you can’t have your cake, and eat it too.

Here on Seeking Alpha, I have a lot of friends in the dividend growth crowd. In fact, it was contributors like David Van Knapp, David Fish, Dividends4Life and Dividend Growth Investor that led me to my semi-religious conversion to dividend investing. It was the best investing decision I have ever made, and I have never looked back.

There is another truism that my dividend growth investor friends hold dear. This truism shows up in nearly every conversation about fixed income versus dividend growth. This truism is this:

“You can’t have your fixed income – and a growing dividend too”.

True…yet not completely true.

Dividend Growth Investing = Passive Growing Income

The argument for dividend growth investing is a strong one. Invest in quality companies that have a history of consistent dividend payout and growth. Hold for the long haul. As long as the company continues to raise the dividend payment every year or two, your dividend will grow. If you reinvest the dividend or accumulate more shares, the power of your growth is maximized. If you do both: watch out!

Thus, the formula for dividend growth with a dividend growth stock is:

Accumulation Phase:

  • Dividend Growth Stock = Dividend Growth, or
  • Dividend Growth + Reinvestment = More Dividend Growth, or
  • Dividend Growth Stock + Accumulation + Reinvestment = Most Dividend Growth

Distribution Phase (Retirement):

  • Dividend Growth Stock = Dividend Growth

It is inherent dividend growth that allows a retiree with mostly dividend growth stocks to kick back and relax. His portfolio is passively growing. In theory there is nothing more he need do to see his income rise in retirement every year.

This is where the rap on fixed income comes in. I have read often this refrain on Seeking Alpha:

Fixed income does not have an increasing dividend. The payout remains the same, month after month, year after year. Therefore, in retirement, your income will not keep up with the rate of inflation. You are doomed to a life of ever-decreasing spending power.

On one hand, they are right. On the other hand, hearing this over and over makes me want to do this:

Let’s settle this once and for all. YES, you can grow your fixed income dividends. The trade-off? It is a LOT more difficult than fixed income investors may realize.

Dividend Growth + Fixed Income = Active Investing

Dividend growth investors become confused about how dividends grow with fixed income because they try to apply the same equation that works with dividend growth investments. In truth, they are absolutely right; the equation does not work. The equation they are using is:

  • (Investment Type) = Dividend Growth

Plug in the word “Dividend Growth Stock”, and the equation is correct. Plug in “Fixed Income” and the equation does not compute.

There is, however, a way to make the equation work. We just need to go back to the original equations I presented, and modify:

Accumulation Phase:

  • Fixed Income = NO Dividend Growth
  • Fixed Income + Reinvestment = Dividend Growth, or
  • Fixed Income + Accumulation + Reinvestment = More Dividend Growth

Distribution Phase (Retirement):

  • Fixed Income = NO Dividend Growth
  • Fixed Income + Reinvestment / Accumulation = Dividend Growth

There is no inherent dividend growth with fixed income. Dividend growth is only inherent if it is passive. Since we cannot achieve fixed income dividend growth passively, we must achieve it actively. Therefore, retirees with a portfolio of fixed income instruments need to actively reinvest in order to achieve dividend growth.

Fixed Income + Significant Reinvestment = Inflation Adjustment

I can hear you fixed income investors complaining already. “But I want to relax in retirement. I don’t want to reinvest. I just want to collect my high yield income while touring America’s wild West in my Winnebago.”

I have news for every retiree, including those with a dividend growth portfolio. There is no such thing as a completely carefree retirement portfolio. Even a 100% dividend growth portfolio requires occasional monitoring to ensure your companies aren’t facing an impending Apocolypse which will decrease or wipe out your dividends.

This holds especially true for retirees – and you guys are legion – who simply have not saved enough to make a 100% dividend growth stock portfolio work at this late juncture of your life. I completely sympathize with your need for higher income in an immediate fashion.

At the same time, I - along with the dividend growth investors - worry about your ability to manage inflation when your dividends don’t passively increase. It’s a greater risk than you may realize.

My second worry is, that you will take the easy road and not frequently reinvest when attempting to address inflation risk.

An initial assumption made at this juncture, by both this author and many a retiree, is this: it won’t cost me that much to make adjustments in my fixed income for inflation. The reality is quite different. I certainly didn’t understand the magnitude of this reality until I dabbled in real numbers. What we will discover is an unpleasant equation that must be reckoned with if you want your fixed income to grow with inflation. This equation is:

  • Fixed Income + Substantial or Frequent Reinvestment = Inflation Adjustment

Dividend Growth + Fixed Income = Quite a Showdown

The principle of growing income by reinvestment and accumulating more shares – whether you are talking dividend growth or fixed income – is easy enough to understand in the Accumulation Phase. Reinvest it all, and any type of dividend instrument experiences dividend growth.

It gets more complicated in the Distribution Phase (Retirement). At the heart of dividend growth for fixed income is this question:

How exactly do you manage a portfolio of fixed income so that the dividends keep up with inflation?

My initial hope in writing this article was to give the retiree hope that higher-yielding fixed income, coupled with reinvestment, would allow him to stand shoulder-to-shoulder with the dividend growth investor that holds lower yield. And, that the process of attaining inflation-proof dividends would be as just as carefree.

All I can say is - I really am a glutton for punishment. Sorry guys. The math doesn’t pan out.

Let’s get this straight right now: comparing dividend growth stocks to fixed income is not like comparing apples to apples. It’s more like apples to oranges, or if I’m really honest, apples to orangutans.

But I took a stab at it anyway. Using David Fish’s Dividend Champions spreadsheet, we find that for the Dividend Champions category, the accumulated average yearly dividend increase is 6.96 percent, or approximately 7%. This handily beats the rate of inflation at 3% to 4% per year.

I then sought out the most apples-to-apples pair of common stocks-to-fixed income pair I could possibly find, using preferred shares. I thought about poking the ribs of my dividend growth investor friends and using (NYSE:GE) vs. (NYSE:GEJ)…oops…that won’t work (snicker, snicker). Instead I somewhat stacked the deck against myself by using an outstanding performer, compared to a comparable preferred counterpart. I also stacked the deck against the preferred share by reinvesting only once a year. You will discover that this would be a fatal mistake for the fixed income investor.

Using 7% dividend growth as a benchmark, I chose NextEra Energy (NYSE:NEE) for the common share, which had an average dividend increase from 2007 – 2010 of 7.45%. This company also offers a preferred share, NextEra Energy Capital Holdings (FGE) with a coupon rate of 7.45%. I figured: this is as close to “apples to apples” as I can get.

To balance the stacked deck against the preferred share, I made the initial dollar investment of the preferred share equal to the common.

(Right off the bat, you retirees have been given a foreshadowing of the results: by investing equal dollar amounts, aren’t you giving up the very reason you want the higher yield in the first place? Don’t you invest in high yield because you believe you don’t have the funds for lower yield?)

I then created my first chart. It attempts to mimic the dividend growth of the common share into the higher-yielding preferred, through reinvestment. Here is my modus operandi:

  1. I started with the initial share purchase.
  2. I then listed the total yearly dollar amount of dividend growth for the dividend growth stock.
  3. In order for the preferred share to match that growth, the next column looks at the number of shares needed for reinvestment.
  4. The next column calculated the actual cost to purchase those reinvested preferred shares.
  5. The final column shows the percentage of income sacrificed to purchase shares, then discloses what is left over after reinvestment.

Click Here to access the DG vs PS Reinvestment spreadsheet.

Granted, comparing (NEE) - a dividend growth juggernaut - to any preferred share is a bit like comparing Andre the Giant to Miny-Me. I also recognize that the reinvestment scheme as presented is far too simplistic. It is - in no way, shape or form - advantageous to the fixed income investor. (There are better ways to implement reinvestment; this is a subject I will address in full at a later time.) Nonetheless, some obvious facts should be staring you in the face:

  • You must increase the number of shares you hold to increase your fixed income dividends.
  • You must sacrifice a significant percentage of your fixed income dividends in order to reinvest.
  • In years of significant dividend increases by DG stocks (NEE increased dividend 10% in 2011), fixed income in NO WAY competes.
  • The dividend increaser will eventually yield more income on less yield, with less investment, than the higher-yielding fixed income instruments.
  • You must actively reinvest fixed income to increase dividends.
  • You don’t have to do squat on the dividend growth stock to increase dividends!

Fixed Income + Real Inflation Adjustment = The Right Formula

Having been smacked down in any expectation I might have to remotely match the dividend increasing power of dividend growth stocks, I am prepared to temper our expectations. My next two charts attempt only to slightly beat, then just keep up with inflation.

The standard benchmark for the average yearly inflation rate is 3% to 4%. Ideally we would like to beat inflation, so our first exercise looks at reinvestment of fixed income dividends to achieve a 4% rate of incremental income.

Click Here to access the DG vs PS Reinvestment 4% spreadsheet.

Fixed income investors: I hear your collective disappointment as I’m writing this. Again, the math does not compute when we reinvest for a 4% inflation rate, at only once a year. Keeping it that simple requires over 50% of your dividend income for reinvestment. This negates the whole purpose in acquiring high yield in the first place.

Finally, our last hope at salvaging fixed income dividend growth is simply to keep up with inflation. The final chart plots once yearly reinvestment to achieve a 3% increase in income.

Click Here to access the DG vs PS Reinvestment 3% spreadsheet.

At last, a ray of hope, at least for a short while. Reinvestment of dividend income to provide inflation-adjusted income at 3% competes somewhat with the dividend growth stock. You are also keeping track with inflation.

The trade-off? You still have to reinvest 40+% of your dividend income to make it happen - if you are only reinvesting once yearly. You will also note that the percentage of reinvestment needed sneaks up in percentage points every year. I’m positive, again, that spending nearly half your yearly fixed income dividends in order to keep pace with inflation was not your ultimate retirement plan.

Cliffhanger + Future Installments = Issues Addressed

In concluding this article, it may appear that I am attempting to diminish the value of fixed income investments and am advocating only dividend growth stocks. Not true. I still maintain there is a place for fixed income in retirement. Instead, what I am trying to communicate to retirees who believe they should only hold fixed income for perceived security is:

  • A higher yield may not be a long-term superior yield.
  • Don’t expect to beat inflation with any fixed income yield if you aren’t reinvesting.
  • Reinvesting only occasionally will require more funds than you expect if you want to keep up with inflation.
  • If you have a 100% fixed income portfolio, you should strongly consider adding dividend growth stocks.

Future articles will address ways to manage your fixed income portfolio so that you can better battle the ravages of inflation. We may also revisit the Dividend Growth vs. Fixed Income Challenge as it pertains to the one sure thing in life other than death: the tax man.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Continue to Part II >>