Investors looking for income haven't faced a tougher environment in decades. Across the financial markets, income is harder than ever to come by, and some tried-and-true relationships between stocks and bonds have gotten turned on their head.
But before you draw the wrong conclusions about the current situation in income investing, you need to look back at history. As it turns out, we've had conditions like this before, and what you can learn from the olden days can help you better understand the right moves for your investments now.
Restoring the old world order
During the financial crisis, something happened that turned a number of heads: The dividend yield on the S&P 500 rose above the yield on the 10-year Treasury bond. For 50 years, yields on bonds had hovered above the S&P's dividend yield, leading some investors to believe that such a relationship was somehow fixed in stone.
Indeed, it's easy to rationalize such a relationship. Bonds offer no prospect for growth; they only give investors the right to interest payments during the bonds' term and to principal repayment at maturity. By contrast, stocks give shareholders the chance at price appreciation as well as dividend income along the way. Since dividends represent only a part of the stock's total return, then that dividend yield should arguably be lower than bond yields.
But what many people may not realize is that before 1958, this rule of thumb was exactly reversed. Dividend yields had almost always been well above similar bond rates. Moreover, it was just as easy to rationalize that relationship: With stocks being riskier than bonds, shareholders needed more incentive to own stocks than bond investors needed to buy bonds. As a result, dividends were higher.
So now that we're again in a period where that relationship appears to be switching back, what conclusions should you draw? Even with high yields, you shouldn't assume that dividend stocks will earn hugely outsized returns in the near future.
Simple give and take
It's tempting to look at dividend yields on popular blue-chip stocks that are higher than bond yields for those companies and decide that the stocks are a huge bargain. For instance, a recent SmartMoney article highlighted companies with strong bond ratings whose stocks yield significantly more in dividends than the yield on their bonds. A couple of the companies currently enjoying such low bond rates, Chevron (NYSE: CVX ) and United Parcel Service (NYSE: UPS ) , are at least somewhat synced with economic cycles. But most of them, including Procter & Gamble (NYSE: PG ) , Johnson & Johnson (NYSE: JNJ ) , and Coca-Cola (NYSE: KO ) , are defensively oriented consumer-goods companies with a reputation for safety and security even during tough market conditions.
The key to understanding the situation now, though, is to understand that dividends and stock-price appreciation aren't independent of each other. If a company pays out more in dividends, it shouldn't see its share price rise as much as a similarly successful company that pays less in dividends. In other words, higher dividend yields may just represent companies paying a greater portion of their earnings out as dividends.
A quick look at payout ratios shows that some substitution of retained earnings for dividends may be going on. For instance, P&G's payout ratio has risen from around the 40% level throughout much of the late 2000s to almost 63% over the past 12 months. J&J's payout ratio shows very similar trends, while UPS routinely had payout ratios in the 35% to 38% range before the financial crisis, compared to more than 50% recently.
Not all stocks are seeing that trend, however. Chevron has had a remarkably consistent payout ratio, although it is more vulnerable to falling energy prices. Coca-Cola, meanwhile, has had payout ratios fall lately, suggesting that it may be generating enough internal growth to justify its dividends.
Take a closer look
I'm not saying that all dividend stocks are a bad investment right now. You should, though, look closely at each individual stock on your watchlist to make sure that you understand the dynamics between its dividend and its earnings. Relying solely on yield could lead you to make a huge mistake.
Learn more about the pros and cons of dividend stocks in our latest special report, "Secure Your Future With 9 Rock-Solid Dividend Stocks." As the name implies, you'll learn about some strong dividend payers, including two of the ones discussed above. Best of all, this report is completely free, so don't miss out!