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Inside the Market What’s making the Toronto Stock Exchange an ‘undercover high-yield market’

After more than six months of shrinking bond yields, the stock market has again become the clear choice for Canadian income investors.

With few attractive fixed-income alternatives, a limited domestic corporate debt market and high-yield options in short supply, the yield-oriented investor has little choice but to turn to dividend-paying equities.

The Canadian stock market serves as a kind of “undercover high-yield market,” with the S&P/TSX Composite Index currently offering nearly twice the yield of Government of Canada 10-year bonds, Ian de Verteuil, head of portfolio strategy for CIBC World Markets, said in a report.

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“So much for Canadian investors saying there aren’t good options for attractive yield with manageable risk.”

While dividend payments can’t be considered as safe as bond coupons, aggregate dividend cuts across a diversified portfolio of stocks tend to be limited to major recessions, Mr. de Verteuil said.

Paltry bond yields, on the other hand, are an enduring feature of the post-global-financial-crisis era.

The rock-bottom interest rates central bankers employed to stave off an economic depression linger a decade later, punishing savers and fixed-income investors.

Last fall, rates and yields showed signs of breaking out of their persistently low range. A resurgent U.S. economy gave the U.S. Federal Reserve the confidence to hike policy rates nine times over three years, while the Bank of Canada implemented its fifth straight hike last October. That same month, the Canadian 10-year yield hit its highest level in nearly five years at 2.6 per cent.

But a growth scare fuelled by trade tensions between the United States and China has seen capital storming back into the safety of bonds, taking the 10-year Canadian yield all the way back down to 1.6 per cent (bond prices and yields move in opposite directions).

The dividend yield on the S&P/TSX Composite Index, on the other hand, sits at about 3.1 per cent.

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Canadian tax rules further support the case for equities over fixed income, Mr. de Verteuil said. While interest earned is treated as income and taxed accordingly, the tax rate on dividends is typically far lower.

Of course, there are risks that come with the higher yield offered by the Canadian stock market. Not only are equities generally more volatile than bonds, but dividends are paid only at the discretion of the company’s board.

But while there is no legal or regulatory deterrent to cutting dividends, there is a practical one.

“When a company puts in a dividend policy, it has to be able to meet that, otherwise, the outcome for them is not pleasant,” said Izet Elmazi, senior portfolio manager at Bristol Gate Capital Partners.

Companies cutting dividends typically see their stocks punished thoroughly, Mr. Elmazi said. “So, it's not a stretch to say that the dividend policies these companies implement are a pretty good view into their true earnings power.”

It’s rare to see dividends cut in aggregate at the index level, Mr. de Verteuil said. “Outside of the income trust debacle [a flood of trust conversions that ended with Ottawa’s decision to tax income trusts in 2006], which temporarily inflated dividend per share, the S&P/TSX Composite Index has only had two declines in the past 30 years.”

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The most recent decline occurred after the crash in crude oil prices, which began in 2014, forced several Canadian energy companies to slash their dividends.

High payout ratios – the proportion of earnings distributed to shareholders – are considered to be one sign of unsustainable dividends. And on that measure the Canadian stock market sits slightly below its long-term average of about 57 per cent, which excludes the troughs and spikes tied to extreme market and economic events, Mr. de Verteuil said.

“The S&P/TSX Composite Index current yield is essentially in line with its long-term average, as are payout ratios, and it offers some of the highest historical relative yields when compared to fixed-income alternatives.”

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