Dividend Cuts – When “Bond Equivalents” Default

bonds-and-stocksAs the ultra-low interest-rate environment of recent years became too much for some bond-focused investors to handle, the search for greener pastures shifted to the equity markets—specifically to dividend-paying bond equivalent stocks.  The allure of blue-chip stocks paying respectable dividends and increasing those dividends on a regular basis can be difficult to resist.  I have a healthy dose of dividend-paying stocks in my portfolio and love the inflation protection that comes from a rising income stream.

I recently stumbled upon an article on Fidelity.com concerning dividend stocks.  In particular, I found the following commentary regarding dividend cuts to be quite interesting:

“On average during the past two decades, 9% of stocks with the highest yields cut or suspended dividends within one year—in 2009, that number reached 40% . . . Historically, the average security that cut or suspended its dividend underperformed the market by more than 25% in the 12-months preceding the announcement.”

In some respects, a dividend cut/suspension is the dividend-growth investor’s equivalent of a default.  And having a default rate in the high-single digits (for the highest-yielding stocks), soaring well into the double-digits during bear markets, is worth paying attention to.  Equally important is the statistic that “the average security that cut or suspended its dividend underperformed the market by more than 25% in the 12-months preceding the announcement [emphasis added].”

If you are the type of investor who would sell your dividend stock because it is no longer providing the income you expect, there’s a good chance that by the time the dividend cut or suspension is announced, the stock will be trading materially lower than where it was several months prior.  Moreover, as the Fidelity article mentioned, “Growth investors may have big winners that can overshadow losers, but income stocks tend to produce steadier returns and have fewer high flyers—magnifying the impact of a big loss . . .”

It’s hard to imagine anyone being happy with negative real yields on shorter-term bonds.  And junk bonds or longer-duration bonds aren’t for everyone.  But negative real yields is the hand the Fed has dealt, and income-focused investors need to do their best to survive.  If survival mode has brought you to the world of so-called bond equivalent stocks, remember that dividends can and do get suspended or cut.  The last bear market is littered with examples of companies that people never imagined would cut the dividends on their stocks.  But indeed, the dividends were cut.  Keep this in mind when you allocate money to dividend-paying “bond equivalents.”

More from The Financial Lexicon:

The 5 Fundamentals of Building a Retirement Portfolio

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