Creating a safe and reliable income stream in today’s financial markets can be like getting water from a stone.
The same rock-bottom interest rates that are fuelling stock markets to record highs have turned governments and corporations stingy when it comes to paying out bond and dividend yields.
“We have a lot of clients that rely on income” says ScotiaMcLeod senior wealth advisor and portfolio manager Winnie Go. She says investors who need safe payouts for day-to-day living expenses have had to settle for returns of less than 4 per cent.
Normally, income investors could rely on government bonds for decent returns but, at less than 2.5 per cent for maturities of less than 5 years, most yields run the risk of getting swallowed by inflation.
With central banks like the U.S. Federal Reserve and the Bank of Canada putting their trend-setting interest rates on hold indefinitely it seems the stream will flow at a trickle for much of 2014.
But for Winnie Go there’s a bright light at the end of the tunnel. Now that the Fed has begun reducing its 5-year long stimulus spending program she expects opportunities for bigger dividend yields to open up starting with interest-rate sensitive sectors like financials – specifically Canada’s profit rich big banks. “They took a hiatus during the financial crisis but we see good profitability, good cash flow and good return to shareholders” she says.
The best dividend growers
The big five Canadian banks have always been among the most generous dividend payers but for dividend growth she’s putting her money on TD Bank, Scotiabank and the Royal Bank of Canada. All three pay annual yields nearing 4 per cent.
She also recommends other sectors that normally pay high dividends but have declined in price, giving investors the chance to buy low and make additional money when the stock rises.
Those sectors include real estate investment trusts (REITS), utilities, pipelines and telecom companies.
Two REITs on her favorites list are H&R, which currently pays an annual dividend yield of 6.3 per cent and Calloway, with a 6.2 per cent annual yield.
Her utility of choice is Brookfield Renewable Energy Partners and its 5.4 per cent yield.
Bigger dividends are expected to flow from pipelines including Enbridge (3.1 per cent) and Inter Pipeline (5 per cent). Pipelines have the ability to increase revenue while keeping costs fixed. “They’re well run businesses” she says.
Shares in Canada’s big three telecom companies have regained much of their losses from the summer but strong dividend payouts continue from Rogers Communications (3.7 per cent), Telus (4 per cent), and BCE. “Even at these prices you’re getting some really decent yields. BCE is still yielding over 5 per cent now” she says.
Don’t count bonds out
Winnie Go doesn’t write off bonds entirely – especially for investors focused on lowering overall risk in their portfolios. Government yields are already inching up as the Fed begins the process of tapering stimulus spending, and letting the economy grow on its own.
“If you get higher interest rates you can potentially shift some of your money to more traditional fixed income yielding products” she says, even suggesting short-term guaranteed investment certificates (GICs) which most often pay less than 2 per cent.
As a general rule, bond yields rise in proportion to their default risk. That’s why governments with the ability to generate revenue through taxation don’t need to pay lenders much. Corporations, on the other hand, pay much higher yields because they can only raise revenue by selling their products. “They’re paying you to take on more risk” she says.
Corporate bond yields are often lower than their dividend yields in this interest rate environment but Winnie Go says durations of less than 3 years for investment grade companies could still pay up to 3.5 per cent.
She advises investors willing to take more risk for higher corporate yields to first look at how the company’s debt is ranked by rating agencies like Moody’s, Standard & Poor’s and Dominion Bond Rating Services. “You want to look at the credit rating and risk profile of that company” she says. “Make sure it’s also a company you would buy the common stock for. If something were to happen to that company the bond holders are first in line”
Finally, she suggests investors diversify their income holdings much like they would diversify their equity holdings. Returns can be maximized and risk minimized with a broad mix of dividend stocks from a range of sectors, and bonds of various levels of risk and terms to maturity. “If you own individual securities and one company runs into trouble and cuts its dividend, you want to diversify to mitigate and manage risk.”