Chris’ note: As regular readers will know, we’re fans of dividend investing here at the Cut. Setting up rising streams of stock market income is one of the safest ways to grow your wealth over time.
But some dividend stocks are stronger than others. And when investors can earn more than 5% on a short-term Treasury bill, it will pressure weaker dividend payers. And some will crack.
That’s the warning today from friend of Legacy Research, Frank Curzio.
He’s the founder and CEO of independent newsletter publisher Curzio Research. He also hosts the podcast Wall Street Unplugged. With more than 11 million downloads, it’s one of the most popular financial podcasts in the world.
And one of his main messages to his readers and listeners right now is to be careful about which dividend stocks you own.
Dividends matter to investors.
Historically, buying stocks that paid dividends has been a great way to generate and build wealth.
A study by S&P Dow Jones Indices found that dividend-paying stocks have outperformed the S&P 500 by an average of 3% a year since 1930.
But with yields on bonds shooting up in the wake of the Fed’s rate hiking cycle over the past 18 months, that’s changing.
Now, you can earn 5.5% on a super safe 6-month Treasury bill. This creates stiff competition for dividend-paying stocks.
That means avoiding some of the highest-paying dividend stocks on the market today.
Before we get to that, you need to understand how we got here.
Desperate for Yields
The 2008 crash changed everything…
As the crisis unfolded, the Fed slashed interest rates to near zero. The idea was to spur economic growth… and avoid a catastrophic global meltdown.
For more than a decade, savings accounts paid next to nothing in interest – and many paid nothing.
It’s the same story for bonds. In 2008, the yield on the 10-Year Treasury bill was cut in half – from 4.3% to 2.1%.
And it continued to shrink from there…
At the height of the pandemic panic in 2020 when investors rushed into bonds, the 10-Year U.S. Treasury yield hit an all-time low of 0.3%.
This left investors desperate for yields. With interest rates and bond yields near 0% for so long, it was impossible to find low-risk investments that offered a decent return.
Many companies took advantage of this. They set aside a bigger percentage of their earnings for dividends. This acted like a “sweetener” to get more investors to purchase their stock.
It worked like a charm…
From 2012 to 2022, U.S. companies paid shareholders more than $3 trillion in dividends. And total dividend payouts grew, on average, 4–5% each year.
Fast forward to today, and it’s a different story.
Highest Yield in 22 Years
Since March 2022, the Fed has hiked rates 11 times to fight the worst inflation since the early 1980s.
The Fed’s target rate is now 5.3%. That’s its highest level in 22 years.
When the Fed raises rates, it pushes the cost of credit. This slows spending… which curbs inflation.
But there’s a flip side…
High interest rates also push up bond yields. This makes it easier to earn solid returns while taking on zero risk.
The 6-Month Treasury bill is one of the safest bonds in the world. It yields 5.5%. That’s up from 0.6% in March 2022 when the Fed began hiking rates.
Now that you can earn a 5.5% yield while taking on extremely low risk… there’s less demand for dividend stocks.
Why take on the risk of owning the S&P 500, which yields 1.6%, when you can generate 3x the income on a short-term bond with hardly any risk at all?
And that’s bad news for five dividend-paying stocks in particular.
With the risk-free rate at more than 5%, companies can no longer use a high dividend yield as a sweetener to lure investors to buy their stock.
The competition from government-backed bonds is too intense…
Instead, management teams will need to invest in growth initiatives to drive share performance. Think acquisitions, share buybacks, and technology.
And high-dividend-paying companies that aren’t growing sales and earnings will see their stocks underperform the rest of the market.
That brings us to my list of five dividend stocks to avoid…
These five stocks – AbbVie, Pfizer, UPS, HP, and International Paper –have dividend yields ranging from 3.5% to 7.1%.
But none of them are expected to grow sales or earnings over the next two years.
That means they’ll have less cash coming in to invest in the business… pay down debt… or even pay dividends to shareholders.
When a company cuts a dividend, shares tend to drop. They can even start to drop in anticipation of a dividend cut. That’s why you want to get out early when companies are still warning about declining sales.
So, avoid these five stocks.
And do some research into the dividend-paying stocks in your portfolio. Look for a similar trend. If sales and earnings are headed lower, it’s time to sell.
The steep rise in bond yields is putting the whole sector under pressure. You want to own only the strongest dividend-paying stocks through this difficult period.
Founder and CEO, Curzio Research