The time to dump dividend stocks and turn to bonds is coming

There were no fireworks or marching bands last month when the 10-year U.S. bond yield topped 3 per cent and brought the benchmark to its highest level since 2011. But it got the attention of money managers who have been forced to tap dividend stocks to generate safe income in a decade-long yield drought.

The 10-year U.S. bond yield has since retreated to below 3 per cent as economic growth projections receded, but it remains a key signal that the economy is heating up, and that bond yields are on the rise.

“It’s not at the level yet where we would switch out of equities to go into bonds,” says Zachary Curry, president and portfolio manager at Davis Rea Ltd., whose older clients rely on steady income. He says the 10-year U.S. bond yield needs to hold its ground between 3.5 per cent and 4 per cent to persuade him to shift into bonds.

“It would have to be a lot higher. You can still go into equities that provide higher levels of income that will grow,” he says.

The problem is that as higher bond yields become a certainty, dividend stocks are coming under pressure as an income alternative. When the U.S. 10-year bond crossed that magic 3-per-cent threshold in May, the index that tracks Canadian dividend stocks had fallen nearly 9 per cent since the start of the year.

Mr. Curry admits that finding good dividend stocks today can be challenging, but they do exist.

“Certain income-generating stocks are going to outperform if they have the right balance sheet, and the ones that don’t are really going to get clobbered,” he says. “We focus on companies that grow dividends and have a sustainable, reasonable payout ratio.”

As examples, he notes that big Canadian bank stocks have continued to increase dividends because bank earnings rise with higher lending rates. “Those dividends at 3.5 to 3.75 per cent look pretty good, and the banks have historically grown them,” he says.

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Mr. Curry also holds the pipeline company Keyera Corp., which has grown its annual dividend yield – currently at 4.6 per cent – in line with earnings growth. “Keyera grows their dividend every year, but their payout ratio on a cash basis is still below 60 per cent [of earnings],” he says.

Davis Rea still maintains bond portfolios for more risk-averse clients, but durations are kept below four years to be ready for higher yields. “We’re not necessarily focused on return on capital. We’re focused on return of capital,” says Mr. Curry.

Christine Poole, chief executive officer and managing director of GlobeInvest Capital Management, also maintains small bond portfolios for safety. “The strategy we’ve been doing the last few years is just buying two-year provincial strip bonds and laddering that over two to three years. They’re giving a yield of about 2 per cent right now, and as they mature, hopefully we can invest in a rising-interest-rate environment into higher yields,” she says.

Like Mr. Curry, she doesn’t expect the 10-year U.S. bond yield to move up quickly. “I think if it gets closer to 4 [per cent] we might start re-examining our allocation,” she says.

In the meantime, GlobeInvest is generating income through Canadian bank stocks and utilities.

“It’s a combination of attractive yields from companies that are strong financially and have the ability to grow their dividends every year – if they’ve done so in the past, and management has indicated they can do so in the future,” she says.

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Utilities in GlobeInvest’s portfolio include Algonquin Power and Utilities Corp., which pays an annual dividend yield of 5.2 per cent, and Fortis Inc., which pays a 4.1-per-cent annual dividend and has increased its dividend payout for the past 44 years. “Given the projects Fortis has in their backlog, they can grow their dividend by 6 per cent annually through 2022,” says Ms. Poole.

GlobeInvest also generates income through dividend reset preferred shares, which reset the dividend every five years based on five-year Canada bonds. “We buy the investment-grade issuers that are giving a yield of about 4.5 per cent,” she says.

Hank Cunningham, a veteran bond trader and fixed-income strategist at Odlum Brown Ltd., agrees that dividend stocks beat bonds for income generation – at least for now. He warns investors not to confuse income from dividend stocks with income from bonds, however. “Dividends are not a certainty like a coupon is on an investment-grade bond,” he says.

Mr. Cunningham recommends investors keep a portion of their income in low-risk bonds or guaranteed investment certificates (GICs) in a laddered portfolio regardless of the yield.

“It takes the guesswork out of it, and it’s better than paying a fund manager to guess where rates are going. You actually know when you are going to get your money back,” he says. “You’re probably going to achieve 3 per cent in a laddered portfolio starting today. To get anything more than that you would have to go way out on the risk ladder.”

He also suggests a type of bond termed “floating rate,” where yields are automatically reset to take advantage of higher rates.

Over all, he says, fixed-income investors should continue to be patient. “I think a year from now short-term rates will be 1 per cent higher than they are now,” he predicts.