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Market View

A dividend-growth strategy can compete head-on with fixed-income offerings—and the concept of “yield on cost” helps to explain why.

Income-oriented investors who have turned to bonds to meet their needs are facing some significant obstacles. According to a Bloomberg report, the total face value of negative-yielding corporate and sovereign debt in the Bloomberg Barclays Global Aggregate Index of investment-grade bonds was $11.6 trillion as of September 30. Based on global central bank policies that likely will promote “lower for longer” interest rates, it appears unlikely that yields will increase meaningfully in the near future. 

In addition to scarcity of yield, income-oriented investors face another challenge in today’s markets. While headline inflation may be stuck in low gear for the foreseeable future, many costs confronting retirees continue to increase at a steady pace. An investor who purchases many types of individual bonds faces the prospect of receiving the same coupon for the life of the investment, while living expenses continue to rise.

Equities may help investors address both of these challenges. It’s worth noting that based on dividend yields, many equities recently provided a higher income stream than several different fixed-income investments. [There is, however, no assurance that this trend will continue in the future.] Another, less widely recognized fact is worth considering: Historically, annual dividends received from equities in the S&P 500® Index have increased in 88% of the past 69 years. This annual “raise” can help equity-income investors, and especially those in or near retirement, combat higher costs. Over time, the “yield on cost,” or the annual income divided by the initial investment, of equities may exceed that of fixed income, and continue to increase its advantage.

Chart 1 demonstrates the concept of yield on cost in action. In the first year (1996), $100,000 invested in bonds provided $6,010 in income. This is equal to a 6.01% yield. On the other hand, $100,000 invested in stocks provided $2,419 in annual income, or a 2.42% yield. (Figures shown do not take into account fees or taxes.) Initially, then, an income-oriented investor might prefer the fixed-income investment.

However, as dividends increase over the years, the annual income stream received from the equity portfolio rises. By the end of year 20 (2015), an investor might have received $7,045 in income. This dividend income divided by the initial $100,000 investment results in a yield on cost of 7.04%. The fixed-income investment, however, continues to provide the same $6,010 in annual income, maintaining a 6.01% yield on an initial investment.

 

Chart 1: Over Time, the Yield on Cost of Equities Has the Potential to Exceed That of Fixed Income
Annual income from a $100,000 investment in each of the designated asset classes, 1996–2015

Source: Strategas Research Partners LLC and the U.S. Department of the Treasury.  The chart depicts the annual income from a $100,000 investment made in 1996 in stocks (as represented the S&P 500 Index) and bonds (based on data for the 20-year U.S. Treasury bond from the U.S. Department of the Treasury). Figures shown do not include fees and taxes.
Note: The 20-year U.S. Treasury yield was 6.01%, as of December 29, 1995.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Unfortunately, Chart 1 also highlights one of the risks of relying on equities to meet income needs; while uncommon (as noted above, dividends have risen in 88% of 69 years past), dividends can decrease, as evidenced most drastically in 2008–09.

However, there is one segment of the equity market that has the potential to increase substantially the reliability of dividend income: companies with a consistent record of increasing dividends over a 10-year time horizon. (A 10-year period was chosen as a measure because such an interval typically includes one or more significant economic or market downturns.)

Companies that have raised dividends every year, through good times and bad, do not do so by accident. Such companies must have the ability to raise dividends every year, which would mean that they typically are high-quality firms with strong, growing, and stable businesses. They also have signaled the intention to raise dividends every year—a characteristic that becomes part of their corporate identity. These companies’ past history of increasing dividends even in times of economic weakness is another argument in their favor. [Although, there is no assurance that they will be able to do so in future economic or market downturns.]

 

Chart 2: A Dividend-Growth Portfolio Historically Has Provided a More Consistent Income Stream Than the S&P 500
Annual dividends received from a $100,000 investment, 2005–15

Source: Standard & Poor’s. Dividend growers represented by the S&P 900 10-Year Dividend Growth Index. The Dividend Growth Index is the exclusive property of S&P Dow Jones Indices LLC. Under a contract with Lord Abbett, S&P Dow Jones administers, maintains, and calculates the Dividend Growth Index. S&P Dow Jones and its affiliates shall have no liability for any errors or omissions in calculating the index. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment and should not be relied upon as investment advice. Different indices and economic periods will produce different results. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time.
Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Returning to the concept of yield on cost, the S&P 900 10-Year Dividend Growth Index has a portfolio yield of 2.6% (as of September 29, 2016). From 2005 to 2015, the Dividend Growth Index increased its payout by 82.7%, or 6.2% per year—and the payout never declined on an annual basis. So, after 20 years of growth, if historical trends are any indication, one could project that the index could provide a yield on cost of around 8.8%. This presents an attractive opportunity relative to locking in, for example, the 1.95% yield offered on the 20-year U.S. Treasury (as of September 29, 2016) for the next two decades.

In short, the income stability of a dividend-growth strategy makes this a unique asset class that can help investors who need reliable income, while providing a significant advantage in reliable dividend growth and likely principal growth. In a world where yields on many investments are expected to remain “lower for longer,” this strategy, we believe, becomes especially compelling. 

To learn more about how a dividend growth strategy might provide the stable, increasing income stream many investors need, please read “Dividend Growers: Yield Now—and for the Future.”

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

RELATED FUND
The Lord Abbett Series Fund Calibrated Dividend Growth Fund invests in stocks of large U.S. companies that have a history of increasing dividends.

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