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October 6, 2014

With interest rates at zero, can you rely on income from equities?

In a world of ultra-low interest rates, the quest for income has left many investors stumped. AAA-rated German government bonds with a 5 year maturity currently yield only 0.15% p.a. and even 10 year bonds offer only 0.90%. However, the inflation rate in Germany, UK or US in 2014 is already between 1-2% so investors are likely to lose money after taking inflation, taxes and transaction costs into account. Many investors are therefore looking at the income stream of equities as an alternative.

While equities should be a significant portion of any long-term portfolio, we would be careful to treat dividends as an alternative to the yield of fixed income assets because dividends are much less stable than is generally assumed. We think „yield vs dividends“ is a misleading question and there are better ways out of the current low interest rate environment.

While dividend stocks are very popular with yield-seeking investors at the moment, we think they overlook two additional issues: (1) dividend stocks are today trading significantly above historical valuation and (2) dividend stocks are highly interest rate sensitive, i.e. in a normalising rate environment they are likely to underperform the equity markets.

What are the arguments in favour of dividends?

  • Dividend yields on European and US stocks are quite competitive today. The dividend yield for the DAX for 2014 is 3.0%, Stoxx Europe 600 3.5% and S&P 500 2.0%.
  • While yields on fixed income securities are, well, fixed – the dividends from equities tend to grow over time. For the S&P 500 for example, dividend growth was positive in 39 of the years from 1968 to 2013. Annual dividends only contracted during seven years.

But the stability of dividends (and shares) is not comparable

  • For investors requiring stable yields, dividends are not suitable. From 2008 to 2009 for example, the dividends in the S&P 500 were cut by 21% and the 2008 level was not exceeded until 2012. In Germany, the dividends were cut by 26% in 2009 and they have not even in 2013 recovered to the same levels as in 2008.


  • The real issue isn’t so much the volatiliy of the dividends but the volatility of the underlying shares. Even high quality companies like Nestlé saw their share price drop by nearly 30% during the 2008/9 crisis. Investors of a more nervous predisposition who sold during the panic locked in steep losses.
  • Equities (and thus the focus on dividends) are not suitable for most investors with an investment horizon of less than 5 years. Do NOT rely on stocks for income – dividends are likely to get cut during a recession. Bonds are designed for income and return of principal. Stocks are designed for gains (or losses) depending upon the underlying business performance. Stocks are not income vehicles, but total return vehicles!

„Fixed income yield versus dividend yield“ is the wrong question anyway
The only return investors will get from safe government bonds (if held to maturity) is the coupon payment. In the case of equities however, dividends are only one of many return drivers and therefore the comparison yield vs dividend can be highly misleading. Investors who only focus on dividend yields are neglecting other return components such as growth, share buy-backs, valuation etc. It is better to focus on stocks with low dividends that are growing rapidly, than on stocks with high dividends that grow slowly. The reason for this is that good management teams pay out a conservative amount of free cash flow as dividends, and reinvest most of the free cash flow to grow the business. A typical example of a high dividend but low growth sector would be telecoms and as most unlucky German investors in Deutsche Telekom will be able to attest, a high dividend yield does not compensate in the long-run for a poor share price performance.

Deutsche Telekom

Caveat emptor: the 2 current issues with dividend stocks

  • Dividend stocks are expensive. Yield scarcity across asset classes has driven investors up the risk curve to equities. Their first port of call were high dividend yielding stocks that now got bid up to historically very rich valuation levels. As always, above-average valuation leads to below-average future returns. Value investors will find a more fertile hunting ground with stocks that offer moderate dividend yields and growth. We have highlighted before (see here) European cyclicals such as BMW, Daimler or Siemens as attractive opportunities. The cyclicals sector in Europe currently also offer a much higher cash-to-asset ratio than other sectors which should enable them to grow their dividend faster than the overall market.
  • Dividend stocks are very interest rate sensitive. The outperformance of dividend stocks in the last few years was mainly driven by interest rates dropping to nearly 0%. If interest rates rise, be ready to see dividend stocks underperform the equity market.

CS high dividend yield stocks tend to underperform when treasury yields rise

The right way to think about dividends
Despite the fact that financial theory has long held that dividend policy should be irrelevant to stock returns, one of the biggest trends in recent years has been individual investors rushing to buy dividend-paying stocks. But investors in need of yield should consider the risks, not just the potential carry in any given year. At Ipanema Capital, we manage stocks and bonds for total return. We don’t look at yield as an important guide to future total return in an environment like this. Our focus is on everything that drives the increase of value of an asset. Finally, investors can create their own „dividends“ by selling off pieces of their portfolio since commissions are generally small today if you are with the right broker.

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