Personal Finance: Not all dividends are created equal

Personal Finance: Not all dividends are created equal

September 26th, 2012 by Christopher Hopkins in Business Diary

It is hard for an investor to get paid in a ZIRP (zero interest rate policy) world.

One popular refuge for income investors has been dividend-paying stocks, which have provided cash flow as well as some nice appreciation over the past three years.

However, it is important to understand that dividend investing is not without risk. In particular, one should recognize that income stocks come in a variety of flavors, with significantly differing expectations for long-term consistency.

The core of an equity income portfolio is typically a handful of solid, steady blue chip stocks that have a long history of maintaining or increasing the dividend year in and year out.

Standard & Poor's maintains a list of "dividend aristocrats," stocks that have paid a stable or increasing dividend each quarter for at least 25 years. The aristocrats include many familiar names: Exxon, 3M, Coca-Cola, Proctor and Gamble and Walgreens.

And yet even the most venerable payout histories are subject to the vicissitudes of evolving financial conditions.

General Electric was forced to cut its previously immutable dividend by 68 percent in 2009, joining Motorola, Dow Chemical and a host of other U.S. firms (including most of the big banks). That year the S&P 500 saw its average dividend payment fall 24 percent from the previous year.

Since the dividend represents well over half of the investor's total return, the reduction in payouts naturally resulted in substantial stock price declines, adding insult to injury.

Besides blue chips, other juicy yielders have attracted attention and should be approached with caution and diligence. So-called "pass-through" securities like REITs and MLPs are exempt from corporate income taxation provided they distribute at least 90 percent of their income.

They therefore tend to have very attractive yields. However, unlike the aristocrats that tend to move heaven and earth to avoid cutting dividends, many of these high-yielders' payouts are subject to prompt recision or reduction if earnings slump and cash flows weaken.

One interesting sub-class of pass-through is the mortgage REIT (or mREIT). These firms hold portfolios of mortgage securities, often guaranteed by Fannie Mae or Freddie Mac, and funnel the interest payments to shareholders.

In order to jazz up the payout, they employ significant leverage, borrowing $8 to $10 for each dollar of equity. Since they take out short-term loans in order to make long-term loans (mortgages), they are able to exploit the FED's low interest policy to juice up investor returns. At the moment, 8 percent to 14 percent yields are typical.

Once rates begin to rise, however, watch out. Just as leverage magnifies gains on the upside, it intensifies the losses coming back down. One must remain vigilant and be ready to pull the plug quickly before surrendering previous gains.

Dividend stocks still are popular alternatives to low-yielding CDs and bonds, and can serve as the foundation of a well-balanced portfolio. But remember that payouts are not guaranteed, and ongoing monitoring is always necessary to minimize unpleasant surprises later.

Christopher A. Hopkins CFA, is a vice president at Barnett & Co.