With Bond Yields Forecast to Remain Low, Dividend Stocks Look Better

Dividend Stocks

Low Yields on U.S. treasuries that are projected to extend into the future have more investors eyeing dividend stocks. This can be a fine thought if you know what you’re getting into.

We can learn quite a bit about the future prospects of the economy by looking at the treasury yield curve, which compares yields over periods of one year to 30 years. Looking at the latest numbers, investors who have cash on hand or are perhaps looking to migrate more of their funds from stocks to treasuries are seeing the horizon looking pretty tame indeed these days.

Yields normally increase over time, where for instance a one-year treasury bill will normally yield, or pay out, more than a 2-year note, and as time increases, the yields should as well. This is due to both the time discount of money in combination with what we expect growth rates and inflation to be.

A lot of people pay close attention to what we call the yield curve here, and this is also looked at when deciding what terms of treasuries that we may purchase. The pricing here isn’t just what the Fed forecasts, it is the sum of the views of all participants in the treasury market, participants that are putting huge sums of money behind their views, and seeing this relative demand move the yields in one direction or another.

The Fed does play a significant role in this though. The central bank is of course the ultimate supplier here, because it is their notes that are being traded after all, but also has a big say on the demand side, as they are both a huge seller and huge buyer of treasuries at various times.

This is a major tool of the Fed in fact and they will use this along with setting interest rates as the two main ways that they influence the economy. Investors focus on the interest rate side of things a lot, but often don’t understand how the treasury market affects things, influencing the money supply as surely as interest rate changes do, and more directly as well.

The yield curve does serve as a reliable barometer of what we expect the economy to do over the next while, and this view includes both what is going on at the Fed as well as what is happening in the treasury market overall. This is particularly the case when we look at the risk of a real slowdown, when we get what we call inverted yields, where shorter-term notes actually pay more than longer-term ones.

Things Look Pretty Low and Flat from Here

We have this right now to an extent, with the one-year yield being now at 2.50%, the two yielding 2.46%, and the three and five-year notes providing a 2.42% yield. We have to go to a seven year note to get above what the one-year bill pays, which is just one basis point above the one at 2.51%.

Before we start to panic though, we do need to realize that this inversion is quite modest, and this isn’t screaming recession by any means, although it does speak to growth slowing down. We already are forecasting this though, and it’s these forecasts that are driving down the future yields, rather than inverted yields changing our forecasts, even though we do look at the yield curve as a forecasting tool. Yields do speak to what may happen though in a way that is much more invested than just economists crunching numbers.

Aside from the yield curve telling us a story about the future state of the economy, yields also influence how investors invest their money. Low yields with treasuries cause investors who have bigger appetites for gains to look to alternatives, and from a return standpoint, lesser quality debt instruments, preferred shares, and even higher dividend common shares may all become more attractive.

As the demand for these other investments increases, this competes with demand for treasuries and causes treasury yields to further decline. This is one of the reasons why we don’t just want to see treasury yields in a vacuum, where they would forecast the state of the economy directly, as some of this is also caused by an increase in the attractiveness of competing investments.

This does work the other way as well, and falling yields on treasuries certainly stimulates these other markets, especially with a lot of money in play, as we have now. Those who make their living recommending conservative equity investments are getting more exited here and are more than willing to proclaim the virtues of dividend stocks.

Owning common stock of any sort is riskier than bonds, and especially treasury bills and notes, but this at least tends to be a more conservative approach than buying entire indexes or focusing primarily on capital growth and is therefore at least more aligned with the risk appetite of investors who treasuries appeal to.

Stock Investing is an Entirely Different Experience

However, common stock is a long way away from treasuries, and do require a big adjustment for investors whose view is so conservative that they would prefer treasuries under normal circumstances. Treasuries are the benchmark for what we call risk-free investing, and while there is always some risk involved whenever we put our money into something, the risk with treasuries is so low that it is simply ignored, which is very much appropriate.

The biggest difference with common stocks is that, unlike with bills, notes and bonds, and even preferred stock, which are basically set-and-forget investments for investors, common stock is much more difficult to set and forget. While we do focus a lot more on dividends with common stock dividend plays, the price of these stocks does fluctuate as well.

They may not fluctuate as much as growth stocks do, but they still do move, and this involves more than just having investors stay the course as they are told to do. This is all about risk, and we are still subject to long periods of poor price performance that normal stock investors have to grapple with, even though this may be muted by selecting stocks that are less volatile from a price standpoint.

Unmanaged stock positions involve a huge amount of risk, whereas with bonds and notes you can just hold them to maturity and not worry about price movement. If you do that with common stock, take on an unmanaged position, you take on whatever risk comes your way, with no limitations.

This approach is one that many investors are fine with, whether it is a good approach or not overall, but they at least know what they are in for, where more conservative investors can become bewildered when they see big chunks of their principal lost, as can and does happen in a bear market. They may indeed sell but without any clear direction and often at very inappropriate times, way too late usually, and often around the bottom.

Still though, stock fund managers and those who sell them would love to get more ultra-conservative investors who favor treasuries on board, and treasuries have the least potential for profit among investments, and the appeal of higher returns does speak to some of these investors at least in a way that can be influential.

The important thing though is to make sure that your risk appetite matches the investment. Advisors are supposed to take steps to make sure that this is the case, within reason anyway, but the combination of their zeal to sell riskier investments combined with the frustration of the investors with the low yields with treasuries that we have nowadays and their yearning to shoot for more may leave some investors in a situation that is out of their element.

It is not enough for a strategy to make more sense from an economic perspective, we also need to be sufficiently comfortable with it, and it also needs to match up with our goals and needs well enough. If someone is looking to draw from their portfolio soon for instance, their risk appetite may be high enough, but their time horizon may not be long enough to justify the extra risk, where they may not be able to give these stock investments enough room to breathe and enough time to do their thing to realize their expectations.

It may be true that a lot of people who invest in treasuries are too risk intolerant for their own good, choosing none over some, but if they want to play the stock market, they at least need to realize what they are getting into and how this game is an entirely different one.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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