Analysis: Frustrated investors turn to dividends for income

NEW YORK Tue Aug 17, 2010 1:01pm EDT

A trader works on the floor of the New York Stock Exchange July 28, 2010. REUTERS/Brendan McDermid

A trader works on the floor of the New York Stock Exchange July 28, 2010.

Credit: Reuters/Brendan McDermid

NEW YORK (Reuters) - Frustrated investors watching their incomes evaporate due to plunging bond yields have turned to dividend-paying stocks, and they're being rewarded for it.

In gloomy economic environments where growth is expected to remain sub-par, investors face limited options for safe-havens with at least a modicum of income support. With benchmark 10-year U.S. Treasury yields near 17-month lows, the pendulum is shifting to the salvation of dividends.

"We are seeing a lot of interest, not only for its long-term attributes but because it meets a real near-term need for income," said Daniel Peris, portfolio manager of the Federated Strategic Value Dividend Fund in Pittsburgh.

In the first half of this year, there was a net inflow of $194.4 million for income-producing equity mutual funds following three years of outflows, according to Lipper, a Thomson Reuters company.

The inflow is in contrast to the $18.4 billion net outflow from all U.S. domestic equity funds, according to industry trade group Investment Company Institute.

"Given the heavy outflows from most equity fund classifications this year, positive flows into equity income speaks to investors' desire for increasingly elusive income," said Jeff Tjornehoj, U.S. and Canada research manager at Lipper.

The bet is working out so far this year.

The S&P Dividend Aristocrats index .SPDAUDP, which tracks S&P 500 companies that have boosted dividends for 25 straight years, has outperformed the S&P by roughly 4.5 percent year-to-date.

Since 1926, dividends have accounted for one-third of all total equity returns.

They may benefit from the record amount of cash companies have amassed over three years of severe cost cutting. Standard & Poor's estimates S&P 500 companies had $836.8 billion in cash and equivalents on the books at the end of the first quarter.

Expiration of the tax cuts on dividends and capital gains instituted during the administration of President George W. Bush -- if no action is taken in Congress -- could prompt firms to make special payments before the December 31 cut-off.

ARISTOCRATS

Of the 42 components of the S&P Dividend Aristocrats index, 28 outperformed the broader market, which is down almost 3 percent year-to-date.

The best performer this year among the aristocrats is Family Dollar Stores (FDO.N), up more than 54 percent. The company has paid roughly $58 million in dividends through the first three quarters of fiscal 2010, according to company data.

"I'm looking for capital preservation, and we have this value-based approach," said Kim Caughey, senior equity research analyst at Fort Pitt Capital Group in Pittsburgh.

"I'm happy to receive some yield and I think that has helped these (dividend-paying) stocks a lot," she said.

SCENARIOS

The high likelihood that the Bush-era tax cuts will expire at the end of the year creates a number of scenarios for investors, but more importantly, for companies.

If no change in the laws are made, the tax on dividends will return to marginal personal tax rates, from 15 percent.

President Barack Obama has floated the idea that taxes would not rise for individuals making over $200,000 or families making over $250,000 a year.

"It affects only the very wealthiest people, roughly 3 percent of the population. But those are the biggest owners of these assets and the ones who have the most to sell or not sell," said Roberton Williams, senior fellow with the Tax Policy Center in Washington.

Companies that traditionally pay a dividend, such as utilities, telecommunications or consumer staple providers, may not change their dividend polices. But they are a minority.

Instead, what may happen is that companies that are not traditional dividend payers may hold back what they pay or postpone a dividend altogether because of what they think might be the tax impact on their investors.

Federated's Peris said the consequence of higher tax rates would likely show up not in any individual stock price move, but rather as a drop of a point or two in the aggregate dividend growth of the S&P 500 index.

"In a real-world context, is Grandma going to sell her utility stocks or our fund because the tax rates are going up? For a bunch of reasons, she's not," he said.

Those reasons include the likelihood that the majority of investors will not be in the higher tax brackets and if they were, the alternatives are not that attractive.

(Writing by Daniel Bases; Editing by Dan Grebler)

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