The dividend dilemma, explained

Over the last several years Canadian investors may have noticed something strange happening to their dividend stocks. After decades of faithful service, dividend stocks haven’t been living up to their reputations as less-volatile investments. In fact, since early 2011, dividend payers have actually been getting progressively more volatile than their non-dividend paying cousins. We all thought dividends stocks were supposed to be the safe ones, so what’s going on?

This is one of those “ask one hundred experts and get one hundred answers” type questions. But after looking at the evidence, one trend becomes increasingly clear. If correct, I expect dividend portfolios to behave differently going forward, and continue surprising Canadian investors.

First, we know that dividend stocks are not priced in a vacuum. One way to determine their value is to measure how much an investor would receive if he or she bought a competing income investment, like a safe government bond. That means a company’s yield (the amount of dividends it pays) is not as important as how much higher or lower that yield is compared to something else. This is a rather intuitive concept: a dividend stock paying four percent isn’t such a good deal if you can buy a government bond paying five percent. So if we can accept that one way to price dividend stocks is by their relative value based on government bonds, then maybe government bonds could explain the volatility we’re seeing.

The yield on ten year government bonds has been gradually declining over four decades, from a high of close to 20% in the early 1980s to about 1.5% currently. On a smaller timeline, over the last year we’ve seen bond yields move between a high of 2.05% and a low of 1.32%, a range of 0.73%. But what seems small in today’s absolute terms is actually very large in relative terms. For example, in 2005, the average bond yield was 4.2%. If that bond yield increased by today’s range of 0.73%, it would produce a relative change of only 17% (0.73%/4.2% = 17%). Fast forward to today’s low  interest rate environment, that same change of 0.73% produces a much larger 55% relative difference in rates (0.73%/1.32% = 55%). That means the swings in interest rates we’re seeing today are about three times larger on a relative basis than they were only ten years ago.

So if the swings in interest rates are now three times larger, and the value of dividend stocks is determined partly by these swings, then it follows that dividend stock prices should experience more volatility. This would explain what we’ve been seeing over the last four years. If this relationship continues, and if we remain in a low rate environment for the foreseeable future, then dividend investors should not expect the familiar safety they were once used to. They should instead expect the value of their dividend portfolios to change more frequently and to a larger degree than commonly suggested. Moreover, the broader demographic trend of baby boomers moving into dividend-heavy portfolios and other income products exaggerates this volatility.

Counteracting these forces presents a unique opportunity for more active investors, and those with a growth mindset. Companies that aren’t expected to play the dividend game may even be at a unique historical advantage. Finally, if dividend income is an inescapable portfolio requirement, sticking to companies that can grow their dividends might be a happy medium. 

Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.