Bonds and dividend yields used to have a fairly tight relationship.
If you can get higher yields from bonds, your income for holding riskier equities should increase too.
Not anymore.
A strange thing is happening. Interest rates are spiking yet the market's dividend rate is declining, currently at a measly all time low of ~1% (just beating the previous dot-com bubble low of 1.1%).
What is causing this dividend yield detachment from rates?
The market has gotten extremely concentrated in technology / AI stocks, many of which don’t pay meaningful dividends.
Executive compensation and employee stock issuance (companies paying themselves vs. their stockholders) is dramatically higher than the long-term average.
Tech companies are prioritizing stock buybacks over dividends, mostly to help offset all the employee stock options they keep handing out like candy. Stock buybacks are pretty meaningless to me if the share count keeps rising. One hallmark of the world’s greatest businesses is that they reduce share count over time, rather than diluting their owners.
Earnings multiples are way above average (bigger denominator = lower dividend yield).
All this is a long way of saying, the market doesn’t give a flying hoot about income.
Seasoned real estate investors understand the problem with this.
When you invest in property, you want a meaningful percentage of your potential return to come from income and not just appreciation.
If you look a financial model and all of the return comes from the sale price then that investment is pretty speculative.
Any investment based purely on appreciation is making a heavy bet on capital markets. They need interest rates and valuation multiples to be favorable when it comes time to sell.
Obviously it’s fine to have appreciation-only investments. But I also want a hefty portion of our returns coming from recurring, cold, hard cash.
Maybe it’s the entrepreneur / real estate owner profile of our investor base, but most of us would dramatically prefer to live off growing dividends rather than sell assets to fund our lifestyle.
The Hunt for Income
Ok Brad, I agree - actually getting paid from my investments would be nice. I guess we should just buy a bunch of bonds?
Not so fast….
Going to get a bit wonky here, but stay with me.
The blue line looks a lot like the efficient frontier in Modern Portfolio Theory, the closest thing investing has to a “free lunch.” Combine return streams that don’t move together, one zigs while the other zags, and you can earn more return with less risk.
Whereas lately (the Red line) bonds and stocks are more correlated, moving up and down in tandem. Don’t quote me on this, but I believe the academic term for how bonds are performing is…crappy.
It’s never fun when you buy the supposedly “safe” investment and then lose money. For you golfers out there this is the equivalent of laying-up on a par five and still finding the lake. For you non-golfers out there, this is…infuriating.
Yes, bonds have a place in some client portfolios but personally I’m not in a rush to lend our government money and then watch them methodically deflate away the value of that debt (via money printing).
This new era of above average inflation is killing bonds on a couple fronts.
They haven’t provided much protection when stocks fall. In 2022 bonds tanked right alongside the stock market.
A 3%-4.7% fixed yield sure beats ~1% from the zero interest rate era (ZIRP) but it’s still not much after-tax and adjusted for inflation.
Furthermore, most of our clients realize a dramatically higher personal inflation rate vs. the headline CPI number.
In other words costs for college tuition, medical insurance, travel, restaurants and services are inflating faster than the average consumer basket measured by the government.
Bonds are useful for preserving wealth. But our goal is more ambitious. We want to dramatically outpace inflation while taking less downside risk than a portfolio of just growth / momentum stocks.
That’s why we care so much about growing income.
An investor focused on income growth (i.e. yield-on-cost, my favorite investment metric, which I’ll write more about soon) tends to be less worried about inflation and volatility. Own quality, income-producing assets at reasonable prices and your income stream has the potential to compound through both up and down markets.
Fortunately, there are still plenty of companies that do just that, they’re just not in the top 10 by size and hence barely influence market returns.
The hard part is selecting which of those public companies and private assets can deliver on growing income methodically over time. Get that part right, and the appreciation should take care of itself.
That’s the job, which thankfully I love.
Brad Johnson