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Hockey isn’t the only national pastime being undermined by the pandemic.

Dividend stocks – the great obsession of legions of Canadian investors – have been rendered anemic by the disruptive power of the novel coronavirus.

As a whole, dividend-yielding stocks in Canada offered no protection through the market crash in the winter, nor did they keep pace with the rally that elevated global indexes in the spring.

While the S&P/TSX Composite Index has recouped nearly two-thirds of what was lost in the sell-off, the Dow Jones Canada Select Dividend Index has clawed back just 43 per cent.

Why is the market suddenly allergic to dividends? The answer may lie in the high levels of debt that dividend payers tend to carry.

“Financial leverage tells a big portion of this tale,” Craig Basinger, chief investment officer at Richardson GMP, said in a note to investors. “Companies that have considerable financial flexibility have been holding up much better than those that don’t.”

This is not what Canadian income investors have grown accustomed to. Over the past two decades, dividend indexes have consistently outperformed the Canadian market as a whole, with less volatility and less severe sell-offs. Over that time, the Dow Jones Canada Select Dividend Index has returned an average of 8.1 per cent a year, compared with 6.8 per cent for the S&P/TSX Composite Index.

“Twenty years is more than enough time to hardwire investors to recognize any superior strategy,” Mr. Basinger said.

Canada’s affinity for dividends has spawned an entire financial ecosystem. With the yield on Government of Canada 10-year bonds averaging roughly 2 per cent over the past decade, and with little in the way of a domestic high-yield bond market, income investors have flocked to the stock market.

There are currently at least 693 dividend-focused mutual funds and exchange-traded funds listed on Canadian exchanges, compared with 831 funds in the entire equity category.

This demand for yield provided a powerful incentive for Canadian corporations to pay, raise and sustain dividends.

“Many dividend payers played the game of raising their dividend notionally, so they could stay in certain ETFs,” said Patrick Horan, a portfolio manager with Agilith Capital. “And they did it for years at the sacrifice of their balance sheets.”

Borrowing to return money to shareholders helped to lift corporate debt levels in Canada to nearly the highest in the developed world. Canadian non-financial corporate debt to annual gross domestic product stood at a record 119 per cent in mid-2019, according to the Bank for International Settlements.

The sectors with the highest debt loads are the same ones paying the most generous dividends: telecoms, pipelines and utilities.

When the pandemic upended the global economy in March, it sparked a global rotation away from heavily indebted companies and toward those with stronger balance sheets.

This has become one of the market’s most dominant themes separating winners from losers in the coronavirus era.

In bisecting the Canadian stock market by level of financial leverage, the less-indebted group is down by about 4 per cent year-to-date, while the segment with higher leverage is off by 16 per cent, Mr. Basinger said.

This puts some dividend investors in a tricky spot – potentially overexposed to weak balance sheets amid a dire recession but with few other options for income.

According to a recent Capital Group report, dividend investing in general requires a rethinking amid the pandemic’s economic and corporate carnage.

“A new paradigm is emerging for dividend-paying stocks and, therefore, we believe it is important to upgrade the quality of income-oriented portfolios,” the report said.

Dividend stocks can, and should, remain at the core of Canadian portfolios, Mr. Basinger said. But in addition to standard diversification, investors should be spreading their exposure across the different types of dividend payers – utilities and telecoms, which benefit the most from falling yields, life insurers and other cyclicals at the other end of the spectrum and banks in the middle.

“Ensuring a balanced exposure across the spectrum is ideal, especially if we start to see rising bond yields in the decade ahead.”

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