Foreign investors are buying Canadian and U.S. bonds. This is reducing bond yields to record lows. One way to generate more income and beat inflation is to buy blue chip stocks that are high-quality dividends aristocrats, i.e. stocks that have raised their dividends for at least five years in a row.
Many foreign investors are desperate to shelter their money. As they pile into the bonds of stable governments, the yields on these bonds have become negative. That is, investors are willing to pay stable governments for the ‘privilege’ of buying their bonds. Factor in inflation and the losses are worse.
The idea behind negative yields is that it can stimulate the economy. Rather than lose money from negative yields, many commercial banks will choose to instead lend it to companies and households. In such cases, the commercial banks can earn at least a little money. To the extent that businesses invest and households consume, the economy benefits.
Many foreign investors are purchasing U.S. and Canadian government bonds. For one thing, government finances here are in better shape than those in many European countries—particularly in what are known as the ‘PIGS’ of Europe (Portugal, Italy, Greece, Spain). For another thing, U.S. and Canadian government bond yields remain positive.
As foreign investors buy Canadian and U.S. government bonds, yields are shrinking. This can cause problems. Consider defined-benefit, or DB, pension plans, where you’re guaranteed certain payments. These plans typically use government bond yields to calculate the size of their liabilities. As bond yields drop, the liabilities automatically rise. This is likely to worsen the underfunding of DB pension plans. Companies will have to raise their contributions.
Lower yields can cause problems
Lower yields can also cause problems for commercial banks. Their traditional banking business partly consists of earning generous spreads. That is, paying relatively little on short-term deposits while earning relatively more on long-term loans. With the yield curve flattening, however, the spreads narrow. Fortunately, the banks operate in many businesses.
Lower rates can also inflict hardship on retirees who rely on interest income to pay their bills. First, the inflow of interest income will decline. Second, the interest income will fail to keep up with the increase in the cost of living. Inflation is a form of inter-generational theft that transfers income from bondholders to current workers.
It’s sometimes said that retirees can’t afford to take any risk. That’s why they’re often encouraged to buy government bonds. But our view is that this overlooks the risk of inflation. Over time, this will inexorably erode retirees’ purchasing power.
We believe that even retirees should own some high-quality ‘dividend aristocrats’. These are companies that have raised their dividends for at least five years in a row. Dividend aristocrats give you a number of advantages. First, most yield much more than government bonds. This is true of electricity utilities such as Key stocks Emera Inc. (TSX─EMA) and Fortis Inc.(TSX─FTS); telephone utilities such as Key stocks BCE Inc. (TSX─BCE) and Telus Corp. (TSX─T); pipelines such as Key stocks Enbridge Inc. (TSX─ENB) and TransCanada Corp. (TSX─TRP); the big five Canadian banks and so on. Their dividends will pay you much more cash than government bonds.
(The main risk such stocks face is rising interest rates. That’s because some money would leave stocks for higher-yielding bonds. But we see little risk of higher interest rates anytime soon. So there’s now less risk.)
Seek high, rising, dividends; price gains
Second, all of these are blue chip stocks that regularly raise their dividends. They do so faster than the rate of inflation. So they’ll enable you to gradually improve your standard of living.
Third, high-quality dividend aristocrats are almost certain to go up in price. If they didn’t, their dividend yields would climb year after year. Eventually, the rising dividend yield would become too good to ignore. At that point, income-seeking investors would bid up the share prices.
Attractive and growing dividends along with share price gains are a winning combination.
The Investment Reporter, MPL Communications Inc.
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The Investment Reporter •7/20/16 •