Yield Gap Narrows as Stock Investors Face Risks

For the generation of investors brought up in the tech bull market, dividends were tossed aside as antiquarian chestnuts of a bygone era. After all, who needed a 3% dividend when Microsoft (MSFT) and Amazon.com (AMZN) were rising 20% or more every quarter?

The desire for dividends has returned, especially in the past few years as interest rates fell and investors went searching for yield. To that end, a slew of dividend-oriented funds — including bank-loan, royalty-trust and option-selling — strategies has emerged.

The classic adage of asset allocation, still embraced by many old timers, is that you should subtract your age from 100 to arrive at the total percentage of assets that should be invested in stocks. That is, a 60-year-old man should be, according to the formula, 40% in stocks and 60% in bonds and savings.

With millions of baby boomers either at or nearing retirement, squeezing regular income from an investment portfolio will likely become an even bigger focus. Moreover, with the large variety of funds and options available, many investors are undoubtedly overwhelmed about how to go about achieving regular income while protecting principal.

Let me say from the outset that I don't believe you should simply buy a stock for the dividend. In my experience, the bulk of a security's return comes from price appreciation. This was the case with REITs, royalty trusts, bank-loan funds and a host of other income-oriented securities investors sought out in recent years. Yes, all offered dividends, but the real gravy was made because the securities rose in value, not because of their dividends.

Plus, bullish investors hungry for income often forget dividends can be delayed, reduced or cut altogether, all of which usually leads to a big drop in the underlying security. Witness the carnage felt in Freddie Mac (FRE) last week when the company simply warned about the possibility of a dividend cut.

From a macro perspective, it behooves us to examine the general trend in both the interest paid on bonds and the dividends paid on stocks in making broad decisions about how to allocate assets.

Thanks to sharply lower stock prices, some of the big-cap financials are now sporting weighty dividend yields that are likely causing some income-oriented investors to take note. Citigroup (C), for example, is now yielding 6.80%, Wachovia (WB) 6.24%, Bank of America (BAC) 5.93%, and Keycorp (KEY) 5.80%. Broadly speaking, dividends across the board are higher. The yield on the S&P 500 is now 1.97%, up from 1.77% a year ago.

At the same time, the interest rate available on benchmark government bonds has plummeted, a trend most have attributed to a flight to quality in the wake of the ongoing credit crisis. In the last two months, as nervous investors stashed cash in Treasurys, the 10-year yield has fallen to 4% from roughly 4.6%.

Fears over the credit crunch — investors shunning stocks and buying bonds — is one way to explain these developments. And in the near term, that might be exactly what's happening.

But longer term, it's my belief that the spread between the dividends paid on stocks and the interest paid on bonds will continue to narrow beyond the immediate effect of the credit crisis. More specifically, investors will generally continue to demand higher dividends payments to compensate them for the risk of owning stocks while accepting lower interest payments for the comparative security of owning high-quality bonds. It's a trend likely to be fueled by slower domestic growth and a national demographic that will depend primarily on bonds over stocks as retirement nears.

As I always point out, macro moves take time. But such a change would simply return markets to the paradigm of 50 years ago, when stocks regularly yielded more than bonds. Back in the early 1950s, for example, the yield on the S&P 500 was over 6% but the rate on the 10-year bond was less than 3%. The notion — now long forgotten — was that stocks should yield more than bonds to compensate investors for the added risk of a security much lower down the capital structure.

In the early 1990s, the dividend yield on the S&P 500 was comfortably over 3%, a full percentage point higher than where it now sits. In time, that's a realistic goal of where yields are likely headed for the major indexes. The higher yields now being seen in the beaten-down financial stocks might be a foreshadowing of a larger shift still to come.

Consequently, if economic growth in the U.S. does continue to stagnate, you'll likely see an even more aggressive Federal Reserve look to cut interest rates again. Together, in the next three to five years, index stock yields might top bond rates, a dramatic departure from where the markets now stand.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.