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Dividend Stocks May Best Bonds

Allocating to high-dividend stocks instead of investment-grade bonds is looking to be a low-risk way to get more yield.

With financial market turmoil and steady Federal Reserve policy pushing bond yields to record lows, U.S. dividend-paying stocks may represent an attractive alternative to fixed-income securities.

Markets have tumbled repeatedly over the past year, most recently in response to the Brexit vote in the U.K. The economic and financial uncertainty surrounding these market stumbles has kept the Federal Reserve squeamish over raising interest rates. Given this backdrop, investors have been fleeing to quality — including to investment-grade U.S. bonds.

That flight means lower bond yields. While those yields have been falling, dividend payouts have been rising. The payouts for stocks in the S&P 500 have risen at double-digit rates over the past five years, as corporate balance sheets have improved and activist investors have pushed for greater returns of capital.

As a result, the S&P 500 dividend yield, at 2.1 percent, has climbed above the ten-year Treasury yield, which recently fell below 1.4 percent, for the first time since the late 1950s, according to Deutsche Bank data. “That’s quite an event, bigger than people realize,” says Binky Chadha, the bank’s chief global strategist, in New York. “It tells you dividend equities are very cheap compared to government bonds.”

That makes a strong argument for dividend stocks. “A case can be made for investors with multiyear time horizons looking for a combination of growth and income to focus on a basket of high-quality dividend stocks, rather than high-quality bonds,” says Michael Sheldon, chief investment officer at Northstar Wealth Partners in West Hartford, Connecticut.

U.S. dividend-paying stocks look particularly attractive compared with foreign, developed-country bonds. Because of intensive central bank easing, more than $11.7 trillion of those securities carry negative interest rates.

The global economic and financial-market turmoil of the past year illustrates the need for safe investments. “After Brexit, the search for income is more acute,” says Bill McMahon, chief investment officer for ThomasPartners, a subsidiary of Charles Schwab Corp., in Boston. “So people are scrambling to finance yield in the equity market, where historically they looked at bonds.” Dividend stocks have an advantage over bonds in that the former often appreciate in value over time, whereas the latter are redeemed at par upon maturity.

In choosing dividend stocks, investors should look for companies with investment-grade credit ratings, substantial free cash flow and dividend payout ratios and valuation levels that aren’t too high. At present, many analysts see the technology sector as attractive for dividend stocks. “In the late 1990s, ‘dividends’ was a dirty word for tech companies,” McMahon says. “But in the past ten years, they have turned into solid dividend payers.” Mature tech companies generate and are holding a lot of cash, he points out. In particular, McMahon likes Microsoft Corp. and Texas Instruments.

Outside of tech, because of their weakness over the past year money-center bank stocks have compelling valuations and yields, McMahon says. He recommends JPMorgan Chase & Co. and Wells Fargo & Co. JPMorgan shares have dropped 9.3 percent in the past year and yield 3.1 percent. For Wells Fargo, shares have slipped 17.1 percent and yield 3.2 percent. The banks hold more capital than ever before, and very liquid balance sheets allow them to take advantage of dislocations in fixed-income markets, McMahon says.

Sheldon counsels caution on financial sector stocks, however. For one thing, the big banks face regulatory pressure, and low interest rates have been weighing on their profits. Yields may be attractive in some cases, but dividend growth rates aren’t as high as in other parts of the market, he points out.

Be wary of high-yield stocks, analysts caution. There’s a reason why the yield is high, and it’s often because the stock price has dropped in response to a company’s financial weakness.

Dan Suzuki, senior U.S. equity strategist at Bank of America Merrill Lynch in New York, warns against going overboard on dividend-paying stocks in general. “Because dividend stocks are correlated with interest rates, you are making an active bet on the direction of rates,” he says. “If rates start to go up at some point, that could be a meaningful headwind.” Meanwhile, dividend stock valuations are very expensive, he says. The forward price-earnings ratio of dividend payers in the Russell 1000 is now 16.3, compared with an average of 14.5 going back to 1986, according to Bank of America Merrill Lynch.

Nonetheless, dividend stocks are still cheap compared with government bonds, Chadha stresses. So is now a good time to buy the former rather than the latter? “I’d answer a resounding yes,” he says.

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