Stocks with rising dividends seen as 'Next Corporate Bond'

NEW YORK Fri Feb 8, 2013 12:22pm EST

NEW YORK Feb 8 (Reuters) - The hunt for yield is moving into the U.S. equity market.

Companies that are likely to grow their dividends have been increasingly favored by yield-starved investors for their competitive income-producing shares.

The popularity of equity income stocks, characterized by Barclays as "the next corporate bond," comes against the backdrop of falling yields and investment returns on junk bonds, investment-grade corporate debt and mortgage-backed securities. Rising interest rates are also a concern to fixed-income investors as they put pressure on bond prices.

Bond-like equities present a good alternative for many money managers.

"This feels to me like a shift going on that's different from anything we've seen since the financial crisis," said Don Taylor, who runs the Franklin Rising Dividends Fund for investment firm Franklin Templeton.

The vanishing yield in the credit markets has forced investors into other asset classes.

The average investment-grade corporate bond yield, based on the JP Morgan US Liquid Index (JULI), was 3.62 percent at the end of January, just modestly lower than 4.31 percent at the end of 2011. That is a less than two percentage point advantage over the safe-haven 10-year Treasury yield, which has hovered around two percent in recent weeks.

Even managers who specialize in bonds are leaning toward stocks with growing dividends.

The Eaton Vance Bond Fund, which was launched on January 31, is geared toward investment-grade corporate bonds, but can invest 20 percent of its assets in stocks. Kathleen Gaffney, the fund's lead manager, told Reuters that she will seek stocks with dividend growth.

Dividend-paying stocks aren't bullet-proof.

The strong inflows into stock funds so far this year could prove short-lived if investors revert to a bearish sentiment. Dividends also can, and often are, cut or suspended by companies.

Even if dividends are stable or rising, that doesn't mean the underlying stock is. Last year, 114 dividend-paying stocks fell more than the value of their dividend, according to Howard Silverblatt, senior index analyst at Standard & Poor's.

Dividend-paying stocks also have not had the same kind of love as corporate bonds and junk debt.

In 2012, dividend-paying stocks were under selling pressure because of fears of higher taxes. If U.S. lawmakers had failed to reach a deal to avert Bush-era tax cuts, the upper income bracket could have faced a steep increase on dividend taxes from 15 percent to 39.6 percent.

After including an additional 3.8 percent Medicare surtax on investment income, that tax rate could have become 43.4 percent. Instead, taxes on dividends increased to 23.8 percent, after including the new Medicare surtax that went into effect. The moderate increase was a relief to investors.

In the seven weeks leading up to the "fiscal cliff" deadline on Jan. 1, however, investors fled dividend stocks. Funds that specialize in dividend stocks suffered net outflows of $864 million between November 14 and January 2.

The pressure also may have weighed on overall inflows into the funds last year, according to Tom Roseen, head of research services at Lipper. U.S.-based mutual funds and ETFs that hold dividend stocks reaped inflows of $20.8 billion throughout 2012, which was lower than gains of $30.9 billion in 2011.

Robert McConnaughey, head of equity at Columbia Management, which manages $340 billion in assets, said the firm has shifted substantially out of investment-grade corporate bonds and into stocks with rising dividends. "The place that we find the most compelling are attractive yields," he added.

Barclays recommended 19 stocks from the electric utility, MLP/natural gas infrastructure, and REIT industries. They include Access Midstream Partners, Alexandria Real Estate Equities, and Northeast Utilities.

"These stocks have an average dividend/distribution yield of 3.8 percent, with an average annualized total return potential of 14.8 percent over the next year and an average 0.69 beta, making them attractive versus bond alternatives," the report said.

BOND VOYAGE

"What gets people back into equities is fear of rising interest rates," said Jonathan Golub, chief US equity strategist at UBS, in New York. Golub said that investors will likely consider dividend stocks as an alternative to corporate bonds, which lose their yield advantage as Treasury yields move upward.

Investors have poured $40.3 billion into U.S.-based stock mutual funds and exchange-traded funds so far this year, the best five-week stretch in 13 years, according to Lipper. That sum more than doubles the $18.8 billion that bond funds have received.

Funds that specialize in dividend stocks captured just $1.9 billion of those inflows, a sign that they have yet to reap their full gains, said Roseen of Lipper.

"It does seem to us like there is an awful lot of room to run in terms of a reallocation back to equities," said McConnaughey at Columbia.

The inflows into stock funds come on the heels of a few high-profile investment firms' targeted focus on stock management, including DoubleLine Capital LP, Loomis Sayles & Co., and PIMCO.

Jeffrey Gundlach, DoubleLine's chief executive and chief investment officer, told Reuters in January that "inflows into bonds are very likely to decline" this year as bond funds see weaker returns.

Investors also remain concerned about a sharp selloff in bonds as stocks become more attractive and interest rates rise.

Taylor of Franklin Templeton said that the shift into stocks could continue on strong economic signs such as a housing upswing in the U.S. and improvements surrounding the European debt crisis. He added that rising dividends offer income despite gradual inflation, which eats away at bond returns.

Dividend stocks, meanwhile, could oust bonds as a favorite asset if the inflation scenario plays out. The Federal Reserve's purchases of $85 billion in Treasury and agency mortgage securities heightens that risk.

"There might be money coming out of the bonds this year as soon as people start seeing that what they viewed as safe could actually hurt them," summed up Michael McGowan, portfolio manager at Forward Funds.