For years, income-hungry investors have had to endure the Federal Reserve's policy of keeping interest rates near record lows. Although that's been positive for homeowners and other major borrowers, savers have borne the brunt of the cost of zero-interest rate policy, as the amount of cash they used to get from bank CDs, savings accounts, and bond investments has plunged.
In response, more investors than ever are turning to dividend-paying stocks. With dividend yields that in many cases greatly exceed what you can get on bonds, dividend stocks have become the only viable option for those who rely on regular income from their investment portfolios to meet their needs. Yet as more money flows into dividend stocks, higher valuations raise the question of whether they can provide good total returns -- or whether buying dividend stocks right now is like following the herd off a cliff.
The search for yield
Even with the stock market at all-time highs, money continues to flood into dividend stocks. As an article from IndexUniverse highlighted on Friday, income-starved investors bought huge amounts of new shares in dividend ETFs Vanguard High Dividend Yield (NYSEMKT: VYM ) and iShares High Dividend Equity (NYSEMKT: HDV ) last week. Inflows into the Vanguard ETF amounted to more than $1 billion, boosting the size of the fund by 20%. The smaller iShares ETF saw a 10% rise in its overall assets under management, as more than $280 million got added to the fund.
What's noteworthy about the moves is the emphasis on the highest yields possible. Vanguard has another dividend ETF that focuses more on long-term dividend growth than immediate yield, and that fund has generally been more popular than its high-yield dividend ETF. But now, more investors are piling into the higher-yielding fund.
What a falling bond market may do to dividend stocks
Low bond yields encourage investors to move to higher-yielding stocks. But over the past six months, the yield on the 10-year Treasury has bounced off its summer 2012 lows, rising from below 1.5% to above 2% recently. If bond yields continue to rise, will fickle investors move back to the bond market?
The answer is far from clear. On one hand, higher bond yields will allow conservative investors to get the income they need while moving back into more comfortable territory. Bonds tend to be less volatile than stocks, and if bank CDs start to raise their rates in line with Treasuries, the added benefit of FDIC insurance protection will undoubtedly lure some investors to pull their money out of dividend stocks.
But there's a countervailing trend that could actually lead to less investment in bonds as rates rise. Bond funds have been extremely attractive as investments lately, because their prices have gone up as rates have fallen, producing lucrative total returns. Yet because prices of existing bonds fall when yields go up, returns will look worse for bond funds, making them look less attractive to many performance-chasing investors. Already, popular bond funds have made investors suffer capital losses. For instance, iShares Barclays 20+ Year Treasury ETF (NYSEMKT: TLT ) having lost almost 10% since last July, even including the dividends that fund shareholders have received over that timeframe.
Waiting for the fall
Unfortunately, history suggests that even investors who arguably shouldn't have as much exposure to dividend stocks will resist reducing their stock allocations until after the stock market starts to decline. Already, popular high-yielding stocks have seen big increases in their earnings multiples. Among consumer food and beverage stocks, for instance, both Coca-Cola (NYSE: KO ) and PepsiCo (NYSE: PEP ) have seen their P/E ratios climb significantly over the past couple of years, with multiples approaching 20 even amid the companies' declining demand in the U.S. amid regulatory pressure to address obesity concerns from sugary soft drinks. When stock prices ignore fundamental challenges, it's a reflection of how much demand there is for the stocks' roughly 3% dividend yields.
Combined with the likelihood that investors will flee negative returns in bond funds and add even more money to dividend ETFs and similar income-producing stock investments, the bull market in dividend-paying stocks looks likely to continue for a while longer. The higher dividend stocks go from here, though, the more likely it will be that when the inevitable downturn comes, it will be more violent than most conservative investors are prepared to see.
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