Do you still use dividends for income?

Dividend stocks may no longer be reliable in an uncertain interest rate environment - Steadyhand's Tom Bradley discusses alternative income options

Ruth Saldanha 9 December, 2019 | 12:01AM

 

 

Ruth Saldanha: Investors often look to dividend stocks with steady income, especially in retirement portfolios. Over the past few years, dividend stocks have appreciated well, in part due to lower interest rates. And some investors have even used dividend stocks as a replacement for bonds. Is this a wise strategy? And what are some alternative sources of income generation for investors in an uncertain interest rate environment? Tom Bradley, President and Co-Founder of Steadyhand is here with us to talk about this today.

Tom, thank you so much for being here today.

Tom Bradley: Glad to be here.

Saldanha: For the medium term, what is your outlook on interest rates?

Bradley: Well, I think the bias is either flat or down. I will say though, that interest rates are incredibly hard to predict. And I think we've all had our – been smacked around by what's happened with rates as low as they've gone here. But our real rates are higher than the rest of the world. There seems to be room for them to go down and if we have any softness in our economy, we probably have a little bit down. But I don't think as investors we should be counting for more of that little bonus that we've had due to declining interest rates necessarily, but I think the bias is that way.

Saldanha: What do you think is going to be the impact on dividend stocks?

Bradley: Well, dividend stocks are highly linked to interest rates. And I think investors sometimes forget that it has been a huge howling tailwind behind dividend stocks. We've gone from rates that have been much higher levels down to where we are, it's near zero, frankly, Ruth. So, you think two ways to look at it, one is that people compare it if they're going to buy a stock, they compare to what they could buy in fixed income and they look at the yield difference. And if yields in bonds, for instance, were to go up, it would become more competitive against dividend stocks, perhaps the stock would have to go down so the yield would go up to keep that kind of spacing. So, there's that factor and then some of the stocks that people buy for dividends REITs particularly, are just structurally very interest-rate sensitive. Cap rates followed interest rates very closely. So, as rates have come down, cap rates have come down, meaning valuations on buildings have gone up and it's been spectacular, and they've been – it's been a great sector. But dividend stocks, you never want to forget that they are very tightly linked to rates.

Saldanha: As you've mentioned, because of the income from dividend a lot of investors have decided to replace their bonds with dividend stocks. Is this a sound strategy at all?

Bradley: I think Ruth it's part of the solution. But if you go all in and own just dividend stocks as a replacement for bonds, I think you're setting yourself up for some risks you may not be anticipating. If you think about what bonds do for a portfolio, there are really four elements to it. One is providing some return and clearly, dividend stocks will do a better job at that. The second is income. Yes, probably right now at least, stocks will do a better job. But the third one diversification, smoothing out those returns, helping you get through some of the tough periods in the market? Dividend stocks are stocks, and so they'll be more volatile. And then the fourth one is downside protection. And that's really the ultimate in diversification. What happens when we have a really ugly market? You and I both remember the bank stocks were down I think it was 40% from peak to trough in '08-'09. And so can a retired income investor handle that much volatility, maybe. But I think it's few and far between. So, people have to be careful in that regard.

Saldanha: Is there a case to be made right now to invest in bonds?

Bradley: I think investors it depends. Every situation is different, but I think there's still room for some bonds and portfolios and it is because of that diversification factor. And I know you've done a lot of work on alternative investments and all the other things well, a lot of them provide diversification, but it's unpredictable diversification. So, we don't actually know it's going to be when we really need it, which is when stocks are melting down. High-quality bonds, government bonds, maybe some high-quality corporates, you can pretty much count on them. Maybe they won't go up as much as they did before when rates were higher, but I still think they are the best diversifier we have. So, I think there's a case to have some bonds in a portfolio.

Saldanha: Apart from this, are there any alternative investment income sources that you can think of that investors should consider right now?

Bradley: Well, I think people should take a balanced approach. So, do I think they should own less bonds today than they usually, they did 5 or 10 years ago, absolutely. So, you might mix in there are also bonds I know but higher risk bonds like high yield bonds have a sleeve of that. Preferred I know is a favourite of Canadian investors and as long as you don't get too carried away I mean they are a more volatile element of and, mortgages there are some good mortgage funds – mortgage income funds. And then, of course, the dividend stocks mixing that in but I, I think it really has to be a balanced approach because I've seen too many portfolios where you're all in on high yield, you're all in on preferred. You're all in on dividend stocks, and I think they're setting themselves up for some tough times ahead.

Saldanha: Thank you so much for joining us today Tom.

Bradley: Okay. Thanks Ruth.

Saldanha: FromMorningstar, I'm Ruth Saldana.

About Author

Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca