Understanding Dividend Yields

The search for high dividend yielding stocks continues as investors seek alternatives to the abysmal yields on fixed income securities. A stock yielding 3% in the context of a US Treasury 10-year yield of 1.55%, definitely looks attractive. Well, maybe.

Dividend yield is the projected annual dividend per share of a particular stock, divided by the price. So if General Motors, for instance, is paying an annual dividend of $1.52 per share and the stock is trading at $32, the dividend yield is 4.75%. Far better than the 10 year Treasury.

But there are three important points to remember for those investors buying high dividend yielding stocks. The first consideration is that dividends are declared each quarter by the board of directors and, therefore, can be cut or suspended at any time. We've all seen this happen to stocks like Conocophillips (COP) that announce a dividend cut earlier this year. After entering 2016 with a dividend rate of $0.95, the company cut its dividend in Q2 to $0.79, and in Q3 to $0.49.  The stock now trades at $41, fully 25% off its recent November 2015 high of $55.  Meanwhile, other large integrated oils, not cutting their dividends, have risen considerably over this period.

Second, the dividend yield is an annual number. In other words, if you purchase the stock, hold it for a year and the dividend rate does not change you earn a dividend yield, in the case of GM, above, of 4.75%. Now, of course, what is important to investors is not the annual dividend yield, but rather the total return in holding the stock. For instance, taking this same example, if you buy GM today at $32 and it closes one year from today at $30.5, just one and one-half point lower, your total return for the year is exactly zero - quite a bit less than the yield on that US Treasury.

These two considerations are fairly obvious, but there is one more point for dividend investors that's often overlooked. The dividend yield when you purchase a stock is only the projected yield you are to receive (assuming no cut to the dividend rate) at the price at which you acquire the stock. In the example above, the dividend yield for GM purchased at a share price of $32 today is projected to be 4.75%. 

But what happens to your yield over time, is of equal importance. Let's say that you find GM an attractive investment at the prices and yields mentioned. Now, let's say that you hold GM for a year and the price rises to $35. Well, you've done quite well on the investment. Your total return for the year would be $14.12% (9.375% in price, plus a 4.75% dividend). But at this point, assuming no increase in dividend rate, your projected dividend yield has fallen to 4.34%. Still a very impressive yield. But for stocks that have risen appreciably, the current estimated dividend yield may be far less than when the investor purchased the stock. As such, investors should periodically reconsider why they are holding the stock and its estimated dividend yield on capital currently deployed.

Is a Fed Rate Hike Good for Bank Stocks?

With talk of a Fed rate hike at its September meeting increasing, following comments of Stanley Fischer and other Fed governors at Jackson Hole, bank stocks are enjoying quite a run. Bank of America is currently trading at $16.14, a nearly 45% gain from its February 2016 lows.  Citigroup is up 38% and JP Morgan +28.5% (a nice game for Mr. Dimon who publicly purchased $26 million of its shares on February 12). The financial services ETF, "XLF" is up an impressive 27.5%.

Some of this gain was a bounce off the February lows, but a healthy share of the return has been produced over the past 30 days as focus turned toward the Fed's Jackson Hole Symposium. Rightly or wrongly, the market thoroughly believes that higher rates are good for banks, as long-suffering bank net interest margins profit by a higher interest rate lending environment.

Truth be known, a hike in the Fed funds rate, in and of itself, is negative for bank earnings. Such a rise in short term rates has to be accompanied by a far larger increase in term lending rates to produce net interest income benefit to the banks. Part of this disconnect has to do with the mystery surrounding the Fed. Despite the Fed's noble efforts at transparency, market participants remain convinced that the Fed has secret data insights, not otherwise available to the markets at large. If the Fed is moving on rates, the economy must be heating up and with it the UST 10-year, or so the thinking goes.

Of course, the Fed is not privy to some covert set of data, but rather is looking at the same economic data as everyone else. In fact, their prolonged hesitation over the most minor of (and nearly insignificant) rate increases should be ample evidence that the data on the economy is more confusing than it is compelling. Nonetheless, as the chatter rises, bank stocks head higher while utility stocks, bonds and gold - each of which thrive in a low interest rate environment - drift lower.

This being said, it's probably worth taking a look at how markets actually reacted in the days and weeks following the Fed's 25 basis point rate hike last December.  As discussed in a previous post, in the several weeks following the Fed's December 15, 2015 rate hike, the 10-year UST actually fell in yield (bad for bank earnings, by the way) while utility stocks and gold posted some of their best gains in recent memory. 

The XLF shows a similar phenomena, rising to a close of $24.44 on the day following the Fed decision, up nearly 32% from its August 2015 lows. But in the days that followed, the XLF quickly began to fade, falling nearly 5% the very next day. By the time of the February 2016 lows, the XLF had fallen nearly 20%. Eerily, the XLF today, as we approach the September Fed meeting stands at precisely the same level, $24.56, as it did on the day prior to the December Fed meeting. 

The Fed, Bonds, REITs and Utility Stocks

The Fed is hosting its 2016 annual academic conference in Jackson Hole, Wyoming this weekend.  Fed Chair, Janet Yellen is scheduled to speak. While no interest rate decision will be announced, markets nonetheless are fixated on developments. With little real economic data or interest to move stock and bond prices, traders eagerly await some insight into future rate policy, in hopes of gaining some direction for markets.

We see the impact of Jackson Hole on bond and utility stock prices, and prices for REITs.  Each of these instruments trade as fixed income securities and are, therefore, rightly influenced by trends in interest rates. But, it's actually long term interest rates that impact these instruments over time, not the short end of the curve that the Fed sets.

Utility stocks have performed extraordinarily well over the past six months, as we first pointed out in this blog in April 2016, Investing in Utility Stocks.  Utility stocks as measured by the return on the ETF, XLU, were up 18.8% through August 10 of this year (see Returns on Selected Assets Year to Date).  It's also worth reading our 2016 market predications posted on December 30, 2015 and What's Working in this Market Correction from January 7, 2016.

Over the past few weeks, though, bonds, REITs and utility stocks have given back some of their gains as investors eye a potential rate hike by the Fed.  Let's take a look at how bonds are priced and why I treat utility stocks as the equivalent. Utility stocks generally trade with a high level of dividend yield. Because utility revenues are quite stable, the dividend is therefore predictable and protected, as much as possible, from swings in the economy.  Therefore, as with bonds that pay a fixed level of interest, the value of the utility stock is tied to the discounted future value of the dividend stream. If the dividend is stable, the stock value will rise as the discount rate falls and decline as the discount rate rises.

Markets, of course, are forward looking, which explains why utility stocks are weakening, while no interest hike has actually been scheduled. The Fed also does not directly impact longer term interest rates that are the basis by which utility dividend and bond interest would be discounted. Nonetheless, the markets are fragile and investors anxious.  

If we look at the last Fed hike on December 15, 2015, however, we see a very different picture emerge. The US 10-year rose by 2 basis points to 2.30% in the day following the announcement, eventually rising to a high of 2.32% on December 29.  But the yield began immediate falling thereafter, to 2.00% on January 28, and 1.63% by February 11, 2016. The 10-year yield now sits at 1.55%. The XLU utility ETF, by the way closed on the day of the December Fed hike at 42.33, climbing to 53 on July 6, 2016 (a gain of 25%).

This points to the most interesting aspect of how bonds and utility stocks trade, not on forecasted Federal Funds rates, or perhaps even the US 10-year, but on the forecast of inflation in the economy, as inflation erodes the value of fixed income securities. The point of all this is that if a Fed hike acts to curb growth (and therefore inflation) a rise in the Fed Funds rate could actually act to lower the US-10 year and raise, not lower, the price of bonds and utility stocks. This is precisely what happened following the Fed's December rate hike. There's no reason to believe that this would play out any differently in the months following the next rate increase.