SKARBECK: Stocks that pay dividends can provide yield, safety

January 23, 2010

These are challenging times for savers who demand a high level of safety from their investments. Microscopic yields are being paid to investors who seek to avoid risk of principal loss. Savers who choose to venture into other investment alternatives that offer a bit more incremental yield need to recognize they are taking on more risk.

As it turns out, 2009 saw record inflows into bond funds as investors fled both the volatile stock market and low-yielding money-market funds. And yet, while moving “out on the yield curve” can be quite tempting, investors need to be aware that the quest for yield can lead into traps.

Venturing out of money-market funds, CDs and short-term government securities and into vehicles such as bond funds and longer-term bonds exposes savers to the risk of rising interest rates. As interest rates rise, bonds decline in value with longer maturities vulnerable to the greatest loss of principal.

More surprising has been the strong investor demand for the low-quality, high-yield debt known as junk bonds. A week ago, new junk-bond issuance set a historic record of $11.7 billion—amazing considering that just a year ago junk bonds were avoided like the plague.

Back then, in the midst of indiscriminate selling, junk yields rose into the high teens, which was precisely the time to buy them. Today’s demand for junk comes at the wrong time after a huge 60-percent rally and with yields that have dropped into the single digits. What short memories investors have!

We think investors who are extending maturities and taking more risk in seeking higher-yielding fixed-income securities are making a mistake. This low-interest-rate environment is a product of the fallout of the credit crisis.

The Federal Reserve is maintaining very low short-term rates to restore the health of our financial markets. The low rates are facilitating liquidity to our financial system as it recovers and continues the arduous process of deleveraging. As the economy continues to slowly improve, there will come a time when the Fed will raise interest rates to a more natural level.

So, in a quest for higher yields, what should a saver do? The solution to this conundrum may be the place many investors have fled over the past year—the stock market. In particular, they should consider purchasing high-quality dividend-paying stocks. From today’s starting point, we think investors who are able to look longer term should expect dividend-paying blue-chip stocks to outperform cash and fixed-income investments.

One could even employ a strategy as simple—and gimmicky—as “Dogs of the Dow.” This involves buying the top-10-yielding stocks in the Dow Jones industrial average at year-end: AT&T, Verizon, DuPont, Kraft, Merck, Chevron, McDonalds, Pfizer, Home Depot and Boeing. All possess dividend yields in excess of 3 percent—far above money-fund yields.

For investors who can’t get comfortable owning high-quality stocks and who wish to avoid the risks in long-term bonds, it is probably best to pay heed to Will Rogers’ adage and be less concerned about the return “on” your money and be more concerned about the return “of” your money. Given time, interest rates will rise again to levels that will appeal to short-term savers.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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