- The interest rates have started to gradually come down, where the consequences of it could already be seen across the dividend landscape.
- On the one hand, this implies an immediate portfolio value increase, which is obviously not a negative.
- On the other hand, the reducing interest rates push down the discount rates, which, in turn, inflate asset prices. This has a direct negative and mathematical effect on the dividend yields.
- In the article, I explain in more detail why for dividend investors, who especially are still in a relatively early wealth accumulation phase, this might be an issue.
As many of my followers have noticed it, I am a pure play dividend investor, where the selection criteria of individual securities are based on high initial yields, conservative cash flows and robust balance sheets. Plus, since my overall investment objective is to develop a portfolio that would eventually provide sufficient current income to cover living expenses, it is critical to keep the dividend cut risk low, while maximizing the yield component in order to reach the ~ $50,000 annual income objective sooner.
The recent interest rate environment has generated decent tailwinds for such a yield-focused strategy, as relatively aggressive discount rates have pushed lower the valuations, thereby mathematically rendering the available yields more attractive.
However, here is the issue.
The issue
As the FED has cut the interest rates, the 10-year US Treasury yield has fallen accordingly. Granted, the Fed cannot directly influence the long-end of the curve, but the changes in base rates tend to strongly correlate with the rest of the risk-free rate curve.
The chart below shows how sharply the US 10-year Treasury bond yields have dropped on a YTD basis.
Since most of the common dividend segments (e.g., REITs, midstream energy, infrastructure) fund their operations through the use of long duration borrowings, it gives a sufficient basis for the market to reduce the relevant discount factors, which, in turn, provide an upwards pressure on the multiples.
Here in the chart, I have selected some of my favorite dividend picks, showing how steep the yield declines have been over the past 1-year period.
For example, Realty Income (O
The things get a bit worse if we put the current yields in the context of historical ones that were present before the monetary policy became relatively restrictive. The yield offered by the broader REIT market captures this situation perfectly, showing that even with the recent drops in yields, there is still a lot of room to go to arrive at pre-2022 level.
Now, I am not saying that the interest rates will converge back to what we had prior to FED’s change in its monetary policy stance, but I think it would be fair to assume that more cuts are coming. This will inevitably lead to a continuation of the aforementioned dynamics – i.e., expanding multiples and decreasing yields.
Here one might argue that actually this is not that bad as the increase in valuations means price appreciation of the underlying securities, thus making the overall investment portfolio more valuable.
In a nutshell, I agree, but let’s plot the following situation.
Let’s assume that we have a starting portfolio investment of $1,000 in year 1 that is placed in a 6% yielding asset. Each year in the next 9-year period, there will be an additional $1,000 that will be contributed to a portfolio. All of the dividends are reinvested and there is no dividend growth assumed.
Now we can introduce 2 scenarios:
- Positive scenario – price of the underlying asset remains constant over the relevant investment horizon, allowing investors to reinvest back at the starting 6% yield.
- Negative scenario – price of the underlying asset increasing by 50% so that starting from year 2 onwards, the average yield at which the dividends are reinvested (and $1,000 committed) is at 4%.
Both of these scenarios are plotted in the chart below.
We can see that while the 50% increase in assets does lead to higher portfolio value, by the year 8, the cumulative effects from dividend reinvestments offset this and start to generate positive value difference.
In terms of collected current income, already from year 2 there is a meaningful gap that could be important for yield-driven investors, especially for those, who want to maximize the return component stemming from income to opportunistically invest elsewhere or just use for funding living expenses.
Granted, the situation could be meaningfully different had the portfolio owner accumulated already a larger asset base, with the ensuing contributions playing a less important role. This way, the 50% of portfolio value increase would generate a more sustained positive value difference relative to a scenario in which the increase had not taken place and the yields remained at their initial levels.
The bottom line
The key message I would like to direct towards dividend investors is that the time is really ticking for us to lock in attractive yields before they go down.
On the one hand, the fact that the asset values increase is a clear positive in terms of benefiting from an immediate wealth expansion. On the other hand, the notion of yields decreasing due to asset prices going up leads to foregone opportunities for yield-seeking investors to build portfolios that would distribute juicy income streams in a relatively short time. This is especially a notable negative for dividend investors, who have still plenty of time left until retirement.
All in all, my recommendation would be to remain invested in the market and focus on increasing efforts to make more tangible contributions into a dividend-based portfolio now, while yields are still relatively acceptable.