Updated with two policy statements from the Federal Open Market Committee on Wednesday.
The Treasury Department’s daily yield-curve rates shed light on investors’ fear of a recession and the likelihood that bond yields will remain very low for a long time.
That means income-seeking investors may be best served by making a commitment to dividend stocks — especially shares of companies well-positioned to increase their payouts steadily and significantly.
Bill McMahon, the chief investment officer of ThomasPartners, a subsidiary of Charles Schwab Corp. SCHW, -2.58% that focuses on investment-income growth strategies, shared some examples of stocks that can serve income-seeking investments well over the long term. This is especially important during a period when traditional “quality” sources of income — investment-grade bonds — are yielding so little.
“Our objective is to grow income at a faster rate than inflation,” he said in an interview March 19.
The inverted yield curve
On Tuesday, according to the U.S. Treasury’s own figures, the inverted yield curve looked like this:
| Maturity | Yield |
| One-year U.S. Treasury bill | 2.50% |
| Two-year U.S. Treasury note | 2.46% |
| Three-year U.S. Treasury note | 2.42% |
| Five-year U.S. Treasury note | 2.42% |
| Seven-year U.S. Treasury note | 2.51% |
| 10-year U.S. Treasury bond | 2.61% |
| 20-year U.S. Treasury bond | 2.84% |
| 30-year U.S. Treasury bond | 3.02% |
| Source: U.S. Department of the Treasury | |
So an investor would have to go out seven years for a yield only one basis point higher than the 2.50% yield on one-year Treasury bills. A 10-year commitment would garner only an additional 11 basis points. In his daily commentary March 18, Mark Grant, B. Riley FBR’s chief global strategist for fixed income, wrote that investment-grade, municipal and high-yield (junk) bonds “continue to compress in against Treasurys, as the demand for yield keeps pushing the credit markets onward.”
The world remains awash with cash, for the simple reason that major central banks, including the Federal Reserve, created trillions of dollars in liquidity by purchasing bonds in tremendous qualities during and after the financial crisis of 2008. Central banks’ balance sheets remain bloated. And as Grant pointed out, one reason the yield curve is inverted is that the Fed doesn’t buy short-term paper.
Fed Chairman Jerome Powell said Jan. 31 that the economic case for further increases in the federal funds rate had “weakened.” On Wednesday, the Federal Open Market Committee decided to keep the federal funds target rate in a range of 2.25% to 2.50% and also said it would cut the pace of the Federal Reserve’s balance-sheet reduction in half in May and conclude the reduction of its bond portfolio at the end of September. So we will continue to have an elephant in the room keeping demand for long-term bonds elevated and helping to hold their yields down.
“Investors are expecting an economic slowdown,” McMahon of ThomasPartners said. So long-term income-seeking investors are willing to lock in a 10-year yield as low as 2.61%.
Higher yields, rising payouts
“Our idea is things will be slowing,” McMahon said. “That is natural, but we still like equities more than bonds. We like the dividend growth rates. We don’t necessarily like the macro game. We like the businesses we own.”
ThomasPartners is based in Boston and has about $16 billion in assets under management. The firm’s main strategy is to select quality stocks with attractive dividend yields, while emphasizing companies’ ability and likelihood to increase dividend payments significantly over time.
The S&P 500 Dividend Aristocrats Index SPDAUDP, -0.68% is made up of the 57 S&P 500 SPX, -0.29% companies that have increased dividends on common shares for at least 25 consecutive years. The Aristocrats Index and the ETF that tracks it NOBL, -0.67% are widely covered in the financial media for the simple reason that the Dividend Aristocrats Index has greatly outperformed the S&P 500 over the past 15 years.
But tracking the Dividend Aristocrats is actually a long-term growth strategy — the only criteria for inclusion in the Dividend Aristocrats Index is that the payouts have increased for 25 years, no matter how little. Current yields also don’t matter.
“When bond yields drop again, it just makes our strategy and philosophy more attractive,” said McMahon. “The yield on our portfolio is over 3%, so we’re getting more income than a high-quality bond portfolio.”
It is also important to consider that if you buy shares of a quality company with an attractive dividend yield, and the dividend raises steadily and significantly, then several years later, the yield on your original investment will be much higher.
McMahon explained that his team is able to “manage the portfolio to increase the portfolio income,” by selling stocks and making new investments. “If something hits our price target and we think it is fully valued, we will buy something that isn’t fully valued with an equal or higher dividend yield, to continue growing that portfolio over time,” he said.
Dividend-stock examples
McMahon named three examples of stocks held by ThomasPartners for clients, and also discussed Wells Fargo WFC, -1.96% another holding, when asked about the bank.
Microsoft
Shares of Microsoft MSFT, -0.11% have a dividend yield of only 1.56%, reflecting the tremendous performance of the shares, which have returned 16% in 2019, following a return of 21% in 2018 (when the S&P 500 was down 4.4%, with dividends reinvested).
Microsoft’s current dividend yield may not be particularly attractive, but “they grow the dividend at a nice rate and we think they will continue to grow it,” McMahon said.
Microsoft raised its dividend by 9.5% in September. Over the past five years, the company has increased the payout by an average of 11.5%, according to McMahon.
When analyzing a company’s ability to increase dividends, McMahon’s research team looks at free cash flow — the company’s remaining cash flow after planned capital expenditures. Dividing 12 months’ historical or estimated cash flow is divided by the share price gives you the company’s free cash flow yield. Comparing this to the current dividend yield shows whether the company has “headroom” to increase dividends or take other actions presumably positive for shareholders, including stock repurchases and organic expansion or acquisitions. Negative free cash flow or a free cash flow yield that is lower than the dividend yield may only be a temporary situation related to a change in company’s business strategy. But it is a flag emphasizing the importance of further research before making an investment decision.
Based on free cash flow data for the past 12 reported months supplied by FactSet, Microsoft’s free cash flow yield is 3.49%, leaving plenty of headroom for the company to continue raising dividends significantly.
McMahon described a decision to hold Microsoft in the portfolio as “nothing particularly clever,” but also said, “we like the way the company is positioned for cloud and enterprise. They grow the dividend at a nice rate and we think they will continue to grow it.”
Wells Fargo
Wells Fargo has a dividend yield of 3.50%. The bank’s free cash flow yield over the past 12 months has been 14.93%, showing a great deal of headroom for dividend increases and stock buybacks. The company’s average annual dividend growth rate over the past five years has been 7.2%.
The bank’s dividend yield is much higher than those of the remaining three of the “big four” club of U.S. banks, in part because of the drag on the shares from multiple investigations by regulators of its sales and customer-service practices:
| Company | Ticker | Dividend yield | Total return - 2019 through March 19 | Total return - 2018 |
| Wells Fargo & Co. | WFC, -1.96% | 3.50% | 13% | -22% |
| J.P. Morgan Chase & Co. | JPM, -2.13% | 3.00% | 10% | -7% |
| Citigroup Inc. | C, -2.03% | 2.74% | 27% | -28% |
| Bank of America Corp. | BAC, -3.41% | 2.02% | 21% | -15% |
| Source: FactSet | ||||
Despite the lingering bad feelings from its customer-service scandals and regulatory action, including a moratorium on expanding its total assets, Wells Fargo remains well-capitalized, with very strong loan quality and a clear ability to continue raising dividends.
As the company continues to improve various operations to address regulators’ concerns, “it is a good holding in the interim,” McMahon said. He added that “too much capacity in the mortgage space” has been a challenge for the bank, but also said, “we like Wells Fargo’s diversified business model.”
Genuine Parts
Shares of Genuine Parts GPC, +0.04% have a dividend yield of 2.84%; their free cash flow yield over the past 12 months has been 5.79%. McMahon said the company has increased its dividend for 61 straight years and that the payout has increased by an average 6% over the past five years.
“They have a retail segment, but a larger market supplying to mechanics,” he said.
“They have been very shrewd operators,” McMahon added, citing the company’s acquisition in January of Hennig Fahrzeugteile Group in Germany. He said Genuine Parts is in a “sweet spot” with the aging of auto fleets in the U.S. and Europe.
Eversource Energy
“We tend to be more overweight the offensive sectors [including technology] and underweight the defensive sectors,” which include utilities, real-estate investment trusts and consumer staples, McMahon said.
But he named Eversource Energy ES, +0.03% of Springfield, Mass., as an example. The shares have a dividend yield of 3.05% and over the past five years has increased at an average annual rate of 6.5%, McMahon said.
Eversource is an example of free cash flow yield analysis not being particularly helpful, at least on the surface, because investments in the business cause cash flow to vary tremendously from year to year. Using data for the past 12 months, the company’s free cash flow yield is minus 3.32%.
McMahon explained that the company has been changing its strategy to focus on distribution and transmission of electricity.
“They have sold their last generators,” he said, while adding that he liked the company because of the economic strength of its area of business (New England) and its habit of increasing the dividend by 6% to 7% a year, “which is good for a utility.”
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