The Death of Dividend Aristocrats

As the stock market powered to new all-time highs, many said the reason was simple: There was no alternative to investing in stocks. Whether investors were seeking out income or capital gains, stocks were the place to be, offering the potential for capital gains while paying out yields higher than those on super-safe U.S. Treasuries or bank certificates of deposit (CDs).

With interest rates rising, however, income investors who had to turn to stocks to generate attractive yields on their investment capital no longer have to take stock market risks for attractive returns. In fact, ultra-safe government bonds now match or exceed the yield of the most elite group of dividend stocks.

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Dividend darlings

The market's most beloved dividend stocks are so-called "Dividend Aristocrats," or companies that have raised their dividends for 25 consecutive years or more. Given that a span of a quarter-century often contains several recessions -- and today, the Great Financial Crisis -- only companies with the most sterling balance sheets and commitment to annual dividend increases can make the list. 

For this reason, Dividend Aristocrats are a common starting place for investors who want to generate income from their stock portfolios. The chart below shows the relative number of searches for "Dividend Aristocrats" on Google over the preceding 12-month period versus bond yields at the time. When rates declined, investors started looking for yields in stocks.

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Note that search interest in Dividend Aristocrats surged when 10-year U.S. government bond yields dipped in 2012 and again in 2016. Lacking alternatives, investors turned to Dividend Aristocrats as a way to earn higher yields in a world where high yields were few and far between.

Bonds and CDs yield more than the Dividend Aristocrats

Thanks to several interest-rate increases by the Federal Reserve and investors' expectations for higher inflation -- due to the corporate tax cut and wage gains, primarily -- ultra-safe investments, including certificates of deposit and U.S. government bonds, currently offer higher yields than Dividend Aristocrats for the first time in a very long time.

Data sources: Average and median Dividend Aristocrat yield calculated by author from dividends obtained from NASDAQ.com, stock prices from Google Finance. Treasury Yields from Treasury.gov. Five-Year bank CD rate from Connexus Credit Union, which ranks highest on Bankrate.com.

A five-year CD currently yields about 0.68 percentage points more than the median Dividend Aristocrat stock, without exposing investors to any risk of capital loss, because CDs are insured by the FDIC (banks) and NCUA (credit unions) in amounts up to $250,000 per depositor. And though stocks promise good long-term returns, they're less reliable over shorter periods of time. Only about 80% of the time do stocks generate a positive real return over a five-year period.

Dividend growth fueled by rising payout ratios

In truth, now may be a good time to turn on dividend stocks. The recent experience for dividend investors has been anything but typical, as S&P 500 companies have managed to increase their dividends at an elevated rate by increasing the proportion of earnings they return to shareholders. 

In 2017, S&P 500 companies paid out roughly 40% of their earnings as a dividend, up from 28% of their earnings in 2010, according to data compiled by Aswath Damodaran. Dividend growth outpaced earnings growth, a trend that simply can't go on forever. 

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With the Federal Reserve signaling as many as three quarter-point interest-rate increases in 2018, investors seeking yields may find that earning 3% from a risk-free, five-year CD beats the pants off a 2.4% yield from a portfolio of relatively risky dividend growth stocks. 

The dividend growth investors who emerged during a period of low bond yields and relatively high stock yields may turn back to bonds and other fixed-income investments as rates rise and dividends, as a percentage of corporate earnings, rise to levels where earnings growth, not payout growth, will play a more important factor in driving dividend income higher.