“The past 12 months have been a great ride in the high-yield bond sector, but at this point it makes sense to take some of those profits and move on to a more promising opportunity. This month we make a case for a shift from junk bonds to dividend stocks. A year ago, the credit markets were just beginning to recover. Fear of bankruptcy had pulled high-yield bond values so low that a typical note sold for around half its par value. The Fidelity High Income Fund and Capital & Income Fund were yielding 11-12%, even with sizable cash positions and portfolios that skewed toward creditworthy issuers. Today the spread between high-yield bonds and 10-year treasuries is back down to long-term averages (4-5 percentage points). Bankruptcy risk has plunged, bond issuance has surged, and those who held them through the recovery cycle have been handsomely rewarded.
“While there is still some room to run, the lion’s share of the rebound has already occurred at this point. While we still expect Fidelity’s high-yield bond funds to perform better than its investment-grade funds over the next year, they’re no longer the best opportunity on the horizon.
“Meanwhile, investment-grade corporations are flush with cash. Normally that cash would be used in the pursuit of revenue growth, but with today’s deflationary backdrop there aren’t that many good opportunities. ... So how do you make your stock go up if earnings growth is hard to come by? In the past, the answer might have been to buy back your own stock, but many firms are looking at the high prices they paid for past buybacks and are concluding it wasn’t exactly a smart thing to do. Which brings them to a more traditional form of shareholder compensation: the quarterly dividend.
“Starbucks’ recent decision to start big (its first ever dividend gives the stock a Grande 1.6% yield) suggests that a new crop of growth-oriented companies may be starting to join the ranks of established dividend payers. This can’t happen too soon. In the wake of the financial crisis, many financial firms eliminated their dividend payouts entirely, while others made deep cuts. That made the past 18 months one of the worst dividend-reduction periods in history, as evidenced by today’s S&P 500 dividend yield—which currently runs at a paltry 2%.
“But even without first-time dividend payers, it looks like we’ve reached a turning point. The recent cutting wave eliminated companies with less than robust business models, as well as those who lacked a strong commitment to shareholders. What’s left among today’s dividend stocks is a group of companies who are both willing and able to reward shareholders. As earnings improve and the cash continues to pile up, it’s not hard to guess what will happen next.
“So far this year, there have been dozens of dividend hikes and only a few cuts. Many increases are coming from outside the financial sector, so it appears we’re at the beginning of a long cycle of increased payouts. It may take a while before financial entities come back to the party, but when dividends are eventually restored the S&P 500 could end up with a significant income stream.
“Individual investors could develop a fondness for dividend stocks, too. So far, the market’s recovery has been largely ignored by individuals, many of whom are more comfortable in cash and bonds than stocks. But that will eventually change. And, after several years of making investment decisions based on yield, those who re-embrace stocks may take comfort buying those that offer more than just capital appreciation potential.
“Bottom line, we are most likely entering a period where dividend stocks have the wind at their backs. The fundamentals for dividend stocks are improving, and investor attitudes are shifting in a way that makes dividend stocks more attractive.”
Jack Bowers, Fidelity Monitor
