When it comes to investing for dividends, the only thing most people care about is the percent yield. However, the frequency with which companies pay dividends can vary. But an 8% yield is the same thing regardless of when you get paid, right? Not quite! There are big differences between the compounding effects of different payment frequencies, and it becomes especially apparent when investing for a long period of time. You can use dividend frequencies to your advantage, particularly when investing in high yielding companies such as Prospect Capital (NASDAQ:PSEC) and ARMOUR Residential (NYSE:ARR).
Payment frequencies and where you'll find each one
There are three basic choices for stocks and funds when it comes to paying dividends: annually, quarterly, and monthly. Semi-annual payments are sometimes seen in foreign companies, but are pretty rare.
Annual dividends are mostly paid by mutual funds. For example, T. Rowe Price pays dividends on all but nine of its stock funds. Quarterly payments are by far the most common, and monthly payments are generally seen in the realm of income funds.
However, where you can help your own returns is in those sectors where you have a choice between two different payment frequencies. Good examples of this are two of the highest-paying sectors in the market – mortgage REITs and business development companies (BDCs). In both cases, there are some companies on quarterly schedules and some on monthly schedules. Let's take a look at a few examples of what more frequent compounding can mean for your long-term returns.
A dividend is a dividend, right?
Consider the case of ARMOUR Residential, which is one of the mortgage REITs using leverage to produce extremely high yields. ARMOUR currently pays around 14.5% annually, but it pays on a monthly basis.
ARMOUR's 14.5% dividend becomes an effective 15.3% annual return when compounded quarterly, and with monthly compounding rises to 15.5%. These numbers may sound very close, but can make an enormous difference over a long period of time.
Consider two hypothetical $10,000 investments paying 14.5% annual dividends, one with quarterly distributions and one paying monthly. After 10 years, the monthly payer is worth about $42,260, about 1.7% more than the quarterly paying option, with all other things being equal. After 20 years, the gap widens to a 3.5% advantage for the quarterly payer. Finally, after 30 year of compounding, the monthly paying investment is worth about $755,000, compared to $717,000 for the quarterly payer. This is a difference of more than 5% from just a 0.2% difference in annual yield.
Prospect Capital is one of the largest BDCs and is another excellent example of a great monthly payer. The company currently pays an annual dividend of about 12.3%, which is already among the best in the sector. When taking the monthly payment schedule into account, the annualized yield jumps to more than 13%.
It is also worth noting Prospect is one of the most consistent dividend payers in the market, offering incredible stability for such a high-paying company. Prospect has already declared its monthly dividends through September, and the payout actually increases slightly each month and has gone up consistently since the company switched to monthly dividends in 2010.
The action you can take now
If you think either mortgage REITs or BDCs will perform well, consider monthly paying companies such as ARMOUR or Prospect for your portfolio. In general, companies in these sectors tend to perform similarly to one another, so choosing those that pay monthly gives you an extra edge over those paying quarterly.
The best thing you can do is to invest early and often, and set your holdings up in a dividend reinvestment plan, so your holdings compound automatically over time. A 5% difference in your account value when it comes time to retire can certainly make a big difference!
Matthew Frankel owns shares of Prospect Capital. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.