Dividend stocks likely your best bet

If you think the current low-growth/low-rate environment is hard on clients in their accumulation phase of life, think about what it means to retirees.

Traditionally, retirees could count on interest payments from bonds to fund their retirement, but short-terms interest rates have been in the toilet for over a decade now, leaving few new opportunities for would-be coupon-clippers.

Long-dated bonds have performed well recently, but only in terms of capital gains. Yields have been compressed by the stampede into long-term debt, and there are warnings that bonds represent the next bubble.

The high-yield space offers better returns, but there’s a reason this market segment used to be called “junk” — and many seniors don’t want to reach that far down the quality ladder.

“That leaves equities as the refuge from the low growth, low return environment,” says Avery Shenfeld, chief economist at CIBC. “Reliable dividend paying equities stand out in a non-recessionary, but slow growth world. Cashing dividend cheques, as opposed to paycheques or bond coupons, may be the best way to make some money when others aren’t.”

A new report from CIBC says dividend-paying stocks were the primary drivers of recent gains on the S&P 500 and TSX Composite, which posted their best September performances in 71 and 14 years, respectively. And the trend toward dividend investing is expected to continue as the population ages.

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The dividend yield on the TSX currently trumps the interest yield on the Government of Canada’s 5-year bond by about 70 basis points. Historically, that spread is more like 300 basis points in favour of the bond.

Historically, North American dividend stocks do best when economic growth is less than 2% and the threat of inflation is minimal. If that sounds familiar, it should: that’s where we are today.

Since 1990, Canadian dividend stocks have beaten the overall TSX Composite by about five percentage points when growth is below 2%. In the U.S., dividend stock outperformance soars to nine percentage points above the S&P 500.

The prospects for stronger growth are slim, as the U.S. Federal Reserve is again considering quantitative easing as a stimulus measure.

“We see no end in sight to zero short rates in the U.S.,” says Shenfeld. “Before the Fed even thinks about raising rates, it will have not only delivered another dose of quantitative easing, but started the process of mopping up the extra money by sending bonds back to the market, and perhaps raising the rate on excess reserves. With so many steps to come first, we’ve pushed back the move off of a zero funds rate beyond 2012.”

In Canada, the central bank is unlikely to raise rates from the current 1%, as the widening gap between U.S. and Canadian rates would drive the loonie well beyond parity, choking off exports and economic growth. Shenfeld predicts no rate hikes before the second half of 2011, with “another long pause at 2% in 2012”.

While interest rates stall, CIBC predicts dividend payouts will rise as companies look for ways to reward investors for sticking with them through the downturn.

“While it depends on a number of considerations, high corporate liquidity levels could point to further dividend increases,” says Peter Buchanan, senior economist at CIBC. “Based on cash to sales levels, our analysis suggests TSX Composite members’ cash and cash equivalents are about 20% above historical levels currently.”

The best bets for dividend hikes, he says, are the materials, utilities and consumer staples sectors.

Financials may see dividend increases, after the Office of the Superintendent of Financial Institutions lifted its recommendation that banks conserve capital. Bank of Montreal has already raised its dividend, driving speculation that the other banks will follow suit.

(10/29/10)