As the below chart of S&P 500 dividend yield indicates, up until the mid-1980s, an investor could earn 4% to 5% annually from dividends, with average index yields seldom dropping below 3%. A $1 million portfolio invested in the S&P 500 could generate $40,000 to $50,000 in annual income without selling a single security. However, for the last three decades, dividend yields have been closer to 2% and are currently well below that at 1.4%.
Sources: Standard & Poor’s for current S&P 500 dividend yield. Robert Shiller and his book Irrational Exuberance for historic S&P 500 dividend yields.
The trend for bond yields has been equally disappointing in recent years, as indicated below. After peaking in 1981, long-term interest rates have been on a steady march downward.
Sources: US Treasury for recent 10-year treasury rate. Robert Shiller and his book Irrational Exuberance for historic 10-year treasury yields.
Because many income-based investors have a combination of both equities and bonds in their portfolios, income payouts remained healthy well into the 2000s, as attractive bond interest rates offset lower dividend yields. However, with average dividend yields currently below 2% and 10-year bond rates just above 1%, income investors are feeling pinched.
How Did We Get Here?
For equities, the decline in average yields can largely be blamed on the strength of the US stock market and the increasing importance of the technology sector as an economic engine. In March 2009, when US stocks were bottoming, the dividend yield of the S&P 500 was a respectable 3.6%. From the March 2009 bottom, the S&P 500 has appreciated over 450% through December 31, 2020, and dividend appreciation has simply failed to keep pace. A case in point is the year 2020, with S&P 500 dividend growth of 3.2%, which paled in comparison to the index’s price appreciation of 16%. While it could be justifiably argued that the pandemic and subsequent economic lockdowns disproportionately impacted high-dividend-paying sectors like energy and financials in 2020, the S&P 500’s dividend yield was only modestly higher prior to 2020, with a December 31, 2019 yield of 1.8%. The real culprit to lower yields is that low- and non-dividend-paying companies concentrated in the technology area are becoming larger components of the US economy and equity indices. Emblematic of this trend is the December 2020 S&P 500 addition of Tesla (paying no dividend) and removal of Apartment Investment and Management (4% dividend, historically).
Our Equity Income strategy requires that stocks in the portfolio pay dividends; however, we consider dividend growth potential alongside absolute yield. Currently, this strategy has only a modest yield advantage over the S&P 500 (2.1% versus 1.9%). However, given its emphasis on dividend growth, it has been able to significantly outperform the Lipper Equity Income Index over the last decade. This index is an equal-weighted index of the 30 largest mutual funds within the Lipper Equity Income fund classification, which has a more stringent yield requirement (at least a 25% premium to the US Lipper equity fund universe).
While the yield on our Equity Income strategy is lower than many competitors, the fact that our clients have seen significantly more appreciation ultimately means more income for them. Due to the power of compounding, our clients earn less income as a percent of their portfolios, but because their portfolios are larger due to capital appreciation, our clients get levels of income similar to portfolios that have higher yields but lower capital appreciation.
Declining bond yields are also not easily explained. Lack of inflation is probably a factor. Investors demand higher returns (i.e., higher interest rates) when inflation is higher to compensate them for their lower purchasing power. Since Federal Reserve Chairman Paul Volker’s efforts to rein in inflation in the late 1970s and early 1980s, inflation has been benign in the US. The fact that the Fed has high credibility as a manager of inflation may partially explain why inflation remains low. Another factor may be the continued trend toward globalization and its impacts on price competition. Productivity-enhancing technologies may also be a driver of lower inflation. Another likely driver of lower bond rates is the persistently low lending rates between depository institutions (referred to as the Federal Funds rate in the US) domestically and abroad. The Federal Reserve and other central banks throughout the world have maintained low depository lending rates to stimulate economic growth.
If clients can tolerate slightly more risk, our Core Plus bond strategies offer a higher yield to maturity than our standard fixed-income strategies. Similar to the Equity Income strategy, these bond strategies are designed to provide a higher return via income and capital appreciation than our other fixed-income strategies. The Core Plus bond strategies are investment grade but have a modestly higher risk profile and allow for some exposure to bonds with a rating below investment grade.
What’s an Income Investor to Do?
In this low-yield environment, income-based strategies are being forced to rely, in part, on capital appreciation to have any hope of matching past growth and income. Regarding equities, we would counsel a stronger focus on dividend growth versus an emphasis on mechanically owning the highest yielding stocks. There is a perception among many income-based investors that, when it comes to buying stocks, a company with a hefty dividend is far safer than one with a modest dividend or one where the only possible return comes in the form of price appreciation. As the chart below indicates, focusing on companies with growing dividends versus just automatically buying companies with dividends (regardless of growth) can drive significant outperformance. In fact, there is a significant body of research indicating that investing exclusively in companies with the largest dividends can be riskier and generate lower returns than investing in those with more moderate payouts.
We expect the trends toward lower dividend yields and interest rates to persist for the foreseeable future. As economic lockdowns related to the pandemic are increasingly in the rearview mirror, we do think some of the harder hit dividend-heavy sectors will see improvements. But there will still be the challenge of persistently low yields for the income-focused investor to navigate.
This article is for informational purposes only and should not be construed as investment or legal advice.
If clients can tolerate more risk, our Core Plus strategies have a higher yield to maturity than our standard investment grade strategies. Focusing on companies with growing dividends. versus just blindly buying companies with dividends (regardless of growth) can drive significant outperformance.
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