Two Reasons Why Dividend Stocks Have Room to Run

Two Reasons Why Dividend Stocks Have Room to Run image Dividend Stocks Have Room to RunTwo Reasons Why Dividend Stocks Have Room to RunThanks to artificially low interest rates, the Federal Reserve has taken the “income” out of “fixed income,” and made saving for retirement that much harder for the average American.

Back in the 1980s, the interest rate on a 10-year Treasury was above 15%. Investors planning for retirement could rely on their fixed incomes providing them with solid, reliable profits; they knew what their annual returns would be, and could budget and spend accordingly.

Today, the 10-year Treasury interest rate is less than two percent. That’s not much for the average American to bank on when it comes to retirement investing. In fact, low interest rates have essentially eliminated the chance for Americans to earn a decent income from fixed equities.

In an effort to eke out as much income as possible from their retirement portfolios, investors are turning their attention to high-yield investment stocks. On one level, it makes total sense—replacing one income-generating investment vehicle with another. At the same time, it’s important to remember that dividend stocks are still stocks—and a lot riskier than fixed-income investments.

The current challenge, some contend, is that income-starved investors have elevated dividend stocks to unsustainable levels. Once interest rates begin to rise, investors will pour out of dividend stocks and into the safety of government equities, at which point, dividend-yielding stocks—and their once reliable income—will tumble.

While it is true that dividend-yielding stocks are more popular than ever before, that does not mean they will fall out of favor once the economy rebounds.

Companies are sitting on cash. You need cash to pay out dividends, and companies have been hoarding cash. According to some estimates, cash balances with S&P 500 companies are on track to touch $1.5 trillion—a historic high. (Source: Cox, J., “Companies Are Sitting on More Cash Than Ever Before,” CNBC.com, October 23, 2012, last accessed May 2, 2013.)

Despite the Dow Jones Industrial Average and S&P 500’s record runs, many firms are reluctant to invest in their business or hire new workers, at least until the economic outlook clears. That could be some time away. In March, U.S. unemployment stood at a robust 7.6%; the gross domestic product (GDP) missed estimates, coming in at 2.5%; and first-quarter results were disappointing.

In lean times, a lot of cash is a reflection of good management. Right now, investors see money sitting on the sidelines as a sign of bad management. If businesses aren’t going to put it back into the company, investors want it returned to shareholders.

Pre-retirees (and those who are already enjoying retirement) need income. Born between 1946 and 1964, the baby boomer generation makes up more than one-quarter of the U.S. population and controls the largest portion of the country’s disposable income. And for the next 15-plus years, millions of baby boomers will be retiring, impacting the economy every step of the way.

That said, retirees tend to be more conservative investors who want a steady income stream—the kind that fixed income used to provide. Many dividend stocks do just that. There are hundreds of financially robust companies that have been reliably providing shareholders with quarterly dividends for 10, 20, even 30-plus years.

Unlike bonds and other guaranteed investments, many high-yield dividend stocks increase their payments annually, protecting against inflation. Also, unlike bonds and other fixed-income securities, many high-yield dividend stocks have a long history of appreciating in price, meaning some investors win on both fronts.

Yes, some investors will pull their money out of dividend stocks when the markets actually recover and sink them into government-backed fixed-income vehicles. But it might not always be in their best interest.

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