The Old Road to Safe, Higher Dividend Yields

We’re returning to the 1950s – and even earlier.

Decades ago, retired people who wanted a reliable source of high income didn’t buy certificates of deposit, money market funds, or bonds. They purchased stocks. Dividend yields on stocks were higher than interest rates on quality bonds. Now that we’ve returned to a world of low interest rates, income investors should consider investing in stocks for income.

Yields on safe income vehicles were 6% just a few years ago. Today, subtract inflation, taxes, and expenses, and some income investments pay zero or even less than zero.

Moving from money market funds to long-term bonds is not a good option. The yield on the 10-year treasury bond still is only 3.5%. Even worse, interest rates are very likely to rise over the next few years. That would cause the value of treasury bonds to decline. Corporate bonds and high yield bonds pay higher yields but are not the bargains they were a year ago.  These yields are likely to shrink as the economy improves.

Many stocks and funds can be found with yields that exceed those of safe, short-term debt. There even are quality stocks paying higher yields than 10-year treasury bonds.

Once a company pays a dividend it is unlikely to reduce or eliminate that dividend except in extreme financial conditions. Diversification can reduce the damage one company in financial distress might due to your income and portfolio value.

Stocks dividends, unlike bond interest, are likely to increase over time. A stock or an equity mutual fund also has the potential to appreciate as the economy and corporate profits grow.

High-yielding stocks can decline with the markets, though usually less than the market indexes. Unlike speculative technology stocks, dividend-paying stocks return to their previous values when the market improves.

High-yield stocks became more attractive under the 2003 tax law. Bond interest is taxed as ordinary income with a rate up to 35%, while dividends now have maximum rate of 15%.

Here are some ways to consider investing for income through stocks.

Utility stocks. Utilities have changed since the days when they were recommended to most retired investors. Yields declined, and the industry is much more risky. Many utility mutual funds define their mandate to include telecommunications companies and other high-risk, low yield vehicles. Vanguard recently changed its utility fund into a more diversified fund.

One of the better utility funds is American Century Utilities fund, which recently had a 12-month yield of 3.34%. The FBR American Gas Index fund recently had a yield of over 4%. Each lost 15%-20% in both 2001 and 2002.

Real estate. Real estate investment trusts tend to have high yields. Cohen & Steers Realty shares recently had a 12-month yield of over 5.5%. The Cohen & Steers Equity Income fund, which strives for a higher yield, paid 7.32%. The equity income fund, however, has fairly high expenses. The C shares charge a 12b-1 fee of 0.75%, and annual expenses of 2.04%. The A shares charge a front load of 4.50%, a 12b-1 fee of 0.25%, and annual expenses of 1.41%. (REIT dividends do not quality for the 15% dividend tax rate.)

Diversified funds. A diversified equity income fund won’t concentrate in one stock sector but will have a lower yield. American Century Equity Income did well in the bear market. It returned over 21% in 2000 and 11% in 2001. It lost only 5% in 2002. Its recent 12-month yield was 2.59%. It has no load and low expenses.
Dividends can increase over time, but won’t every year. Fund dividends could decrease.

For example, American Century Equity Income distributed $0.19 per share in income in 1995. This rose to $0.26 in 1997, stayed at $0.22 the next two years, fell to $0.18 the next two years, then fell to $0.16 in 2002. This does not include capital gains distributions or changes in net asset value. CSRSX distributed $1.09 per share in 1994, and this rose steadily to $2.38 per share in 2002. These are income distributions only. That is a more than doubling of income distributions during a time when bond yields were falling.

In a world of low and falling interest rates, investors have to seek other sources of income. As in the 1950s, many stocks and equity mutual funds pay yields equal to or exceeding those of bonds. Unlike interest from bonds, once a company that declares a cash dividend it tries to maintain or increase the payout.