Month: June 2023

Due to their regular cash flow and perceived lower risk, high-dividend paying stocks are popular with investors. But are they a smart option? In this episode of Buckingham Weekly Perspectives, Head of Investment Research Jared Kizer explains the basics of high-dividend paying stocks and shares why we don’t recommend exclusively investing in them.

Transcript:

Jared Kizer: All right. So today I’m going to talk about high-dividend paying stocks as an investment strategy, of course related to the stock portion of the allocation and get into why we generally don’t think that’s a good at least exclusive approach to the stock allocation portion of the portfolio.

What Are They, and Why Are They So Popular?

Jared Kizer: So really briefly on what high-dividend paying stocks are. So stocks can pay a dividend, so this is just a cash flow that you could earn over the course of the years we’ll talk about here in a second. Not all stocks actually pay dividends, and that’s going to be one of the critiques of this approach. But for stocks that do, they may pay, for example, a 5% dividend yield, which means that the stock is trading at $100, that over the course of that year, you can reasonably expect all else equal that you’re going to get paid $5 of cash.

Why Don’t We Recommend Focusing on High-Dividend Paying Stocks?

Jared Kizer: So because investors tend to be tempted toward cash paying strategies, understandably, to some degree, we do tend to see a lot of questions come in about why not specifically focus on high-dividend paying stocks. So let’s cover the three kind of critiques of this type of approach to investing again, at least as an exclusive approach to investing.

Reason #1: Stocks Will Be Stocks

Jared Kizer: So first point being that high-dividend paying stocks are still stocks, meaning they’re going to be responsive like all stocks are to what is going on in the broader economy and of course, specifically what’s going on with those companies. So you don’t necessarily shed yourself of the risk of stock market investing because you do tend to see if the overall stock market is down a lot, that these high-dividend paying stocks tend to be down as well. Very related to this first point is that because these are dividend payments, they’re at the company’s discretion. So you can, you know, own a stock that’s paying that 5% dividend yield, company hits a rough patch and they eliminate the dividend or cut the dividend in half and all of a sudden you’re not receiving the cash flow that you expected you would. So, there’s a good bit of uncertainty there.

Reason #2: Many Companies Don’t Pay Dividends

Jared Kizer: Second point which relates to changes in the market dynamics is it used to be the case 40 or 50 years ago that a very, very large fraction of stocks paid dividends. We’ve seen that change massively over that period of time to a point where a relatively small fraction of companies, certainly compared to years past actually pay dividends. So if you’re focusing only on those types of stocks, you’re likely going to be more concentrated and potentially focusing on specific sectors and just not be as well diversified as we would like investors to be.

Reason #3: Value Investing Offers Diversity

Jared Kizer: Finally, you’ve heard us talk about value investing, which is the concept of buying stocks that are trading at low prices relative to earnings or the book value of the company compared to the broader market. We think that can be a very sensible approach to stock market investing for a lot of investors. And that approach also tends to own the higher-dividend paying companies as part of that broader approach. So it doesn’t only own those companies, but those companies do tend to frequently fall in the value bucket. So that’s a way to have these companies represented in a stock allocation but not be exclusively focused on those companies. So hopefully that’s a good perspective on the way that we think about high-dividend paying stocks. If you have additional questions you like for us to tackle, feel free to reach out to your advisor or click the link below and submit questions in that way.

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Jared Kizer takes a deep dive into high-yield corporate bonds and shares three reasons why these investments are not recommended from an allocation perspective.

Transcript:

So today I’m going to talk about high-yield fixed income investing, what it is and why we generally don’t tend to recommend allocating to high-yield fixed income.

What is High-Yield Fixed Income

So let’s first cover the what it is part. What is high-yield fixed income? So these are publicly-traded securities that pay principal and interest that are issued by relatively financially distressed companies. So they’re publicly traded, but you can think about these companies being smaller companies, companies that are at some higher risk of bankruptcy, say over the next year relative to the companies that we all know better and companies that generally aren’t growing as fast as other companies. So, they’re riskier, but the appeal to investors as you’ll tend to see, as you would hope, markets do tend to offer these fixed income investments at much higher interest rates than say Treasury bonds, municipal bonds or government bonds.

Three Fast Facts About High-Yield Fixed Income

But let’s get into why we generally don’t think allocating to high-yield fixed income make sense and we’ll cover really three different topics and aspects of that perspective.

This Hybrid Security Follows the Lead of the Stock Market

So the first thing is we think of high-yield fixed income is what we would call a hybrid security. That sounds fancy, maybe a little bit complex, but it’s actually a relatively straightforward concept. It is just saying that when you think about high-yield fixed income and these risk issuers being riskier than higher quality issuers, you tend to see that high-yield fixed income will tend to do poorly at the same time that the overall stock market is doing poorly. Meaning because these are financially distressed issuers, they’re more sensitive to negative developments in the economy, so they tend to have aspects that are a little bit like stocks, maybe a little bit like fixed income and tend to be more like stocks at the worst possible time, therefore not providing the diversification that we would like to see from fixed income investments.

There is Less Control Regarding Asset Allocation

That segue ways nicely into my second point, which is because they are this hybrid type of security that’s hard to classify, it does end up muddling the allocation to some degree. So when you think about allocation, we think about allocating to stocks, bonds and alternatives as the three predominant groups of an overall allocation. And here really high-yield fixed income doesn’t necessarily fit cleanly into any one of those buckets. So when you allocate to fixed income, to some degree, you lost control of your overall allocation, muddying the allocation a little bit.

Stocks May Be a Better and More Tax-Friendly Option

I think third is probably the most pertinent point, either the first point or the third point. Being that if you’re comfortable with this type of risk, meaning owning riskier bonds from riskier companies, there’s certainly a good argument I think for just owning the stocks of these companies in a diversified portfolio as some portion of the allocation because you’re likely going to get more favorable tax treatment, just owning the stock versus the fixed income side. And last point I would make as part of point number three is if you’re comfortable with this type of risk, but you want a fixed income type security, we would say private market, middle markets lending, so lending to privately held companies tends to we think over the long term be a better risk return trade off. You just tend to see those private loans have even higher interest rates than high-yield corporate fixed income, so that could be another direction that might make sense to go as an alternative to traditional high-yield fixed income.

So hopefully, that’s a helpful perspective on what high-yield fixed income is and why we don’t generally recommend allocating to it. If you have additional questions you’d like for us to tackle, feel free to reach out to your advisor. Or click the link below and submit questions in that way. Thanks.