Withstand a Recession by Leading With Dividends

Written by: Shiv Patel | Advisor Asset Management

While yields in the economy remain suppressed, dividend-paying stocks have the potential to help fill the income-generation void within investors’ portfolios. However, as the Fed tightened monetary policy, bonds quickly became attractive again as their yields rose up into the 5% range, levels similar to that of high dividend-yielding stocks.

yields of dividend stocks vs treasury yields

Source: FactSet, ICE Data Indices | Past performance is not indicative of future results.

Although these historically high yields at last present an attractive alternative to dividend-paying equities, we believe investors should not be so quick to abandon them entirely. Dividend-paying stocks represent quality companies that are often well-established and financially stable to the extent of being able to return cash to shareholders. These stocks have characteristic that can potentially better help mitigate risks to a portfolio from an economic slowdown relative to broad equities.

In 2022 when markets were hyper focused on the impending recession while also adjusting to rapidly rising interest rates, the S&P 500 High Dividend Index proved to be relatively insulated from broad market declines. As the S&P 500 Index declined 18.1% over the year, the S&P 500 High Dividend Index declined by only 1.1%. The index of high dividend yielding stocks also generated lower volatility on an annualized basis, resulting in a return/risk -0.05 compared to -0.75 for the S&P 500.

2022 return vs 2022 annualized volatility

Source: FactSet | Past performance is not indicative of future results.

This can largely be attributed to the fact that these companies continue to be meaningful sources of income, which can be especially valuable during market downturns or economic uncertainties. The dividend income provided has the potential to meaningfully help curtail downside price return moves and provide a source of positive return. Across the previous year’s market declines, the dividend income of the S&P 500 High Dividend Index contributed 4.03% to its total return for the year. That was just 1.33% for the S&P 500, amounting to a nearly 3% lower contribution percentage of dividend income amongst broad market stocks.

the income return cushion

Source: FactSet | Past performance is not indicative of future results.

Moreover, with Treasury yields approaching or even surpassing the yield of most broad equities, high dividend-yielding stocks still set a higher standard. Currently, the S&P 500 High Dividend Index has a yield of 5.3% compared to 1.6% for the S&P 500. In addition, nearly 54% of the stocks have a dividend yield of greater than 5%, while only 9% of the stocks do for the S&P 500.

S&P 500 high dividend index | S&P 500 index

Source: FactSet | Past performance is not indicative of future results.

Perhaps most importantly, dividend-paying companies are commonly financially healthy. These companies can show durability through tough economic times, as they often have low or manageable debt levels and excess cash. These characteristics are the synergy between dividend and quality stocks. Companies that need to improve their financial health are unlikely to be using their cash to pay dividends and more likely to instead use it to reduce debt. Thus, dividend paying companies can be reliable sign of sustainable financial strength. Currently, 48% for the companies of the S&P 500 High Dividend index have a debt-to-equity ratio of greater than one (more debt than equity) compared to 54% for the companies of the S&P 500. Given their higher levels of debt relative to their equity, as interest rates continue to rise these companies may find it difficult to service this debt let alone use their cash to pay dividends. As a result, stocks paying little, or no dividends could be a sign of exiting or anticipated financial stress.

Leading your portfolio decisions with dividends in mind can be a source of portfolio resiliency as the risks of recession increase and the burden of higher interest rates firmly set in. Dividend-paying stocks, particular those that are likely to sustain their dividends, can potentially reduce volatility, mitigate drawdowns and maintain their financial health throughout worsening economic conditions.

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