LONDON Targeting equities with high dividends has been attractive for some time, but what began as a short-term defensive strategy for some institutional investors fearful over falling bond returns is turning into a flood.
Promises by the Federal Reserve and its peers to keep monetary policy relaxed will keep debt and cash yields low, making the returns on dividends richer than hugging benchmark indexes or buying corporate bonds of the same companies.
The outlook for low interest rates and robust corporate earnings have driven equity risk premia -- the excess return above benchmark central bank rates -- toward record highs, reinforcing the allure of stocks.
In Europe, average dividend yields stand at around 4 percent, more than 1.5 percentage points above benchmark government bonds and also competitive with yields on triple-B rated investment corporate bonds near 5 percent.
Calculations by U.S.-based Federated Investors shows total returns for dividend-paying firms have outpaced the broader market by nearly 190 basis points since January and U.S. firms have been most generous in dividend payouts since at least 2003.
"If you believe developed markets are in a range for some period, and if you get four percent, why wouldn't I do it?" said Mark Stoeckle, chief investment officer for U.S. equities at BNP Paribas Asset Management. "Dividend is a sign of confidence."
Stoeckle said his team has started taking dividends into account for the first time when making stock selections.
JP Morgan says exchange-traded funds tracking stocks with high dividends are seeing record inflows.
Flows into ETFs tracking preferred shares, high-dividend stocks and convertible bond with a market capitalization of more than $200 million attracted $1.3 billion so far in September, having seen a record $1.36 billion in August.
In the United States, at least a dozen major companies offer higher dividend yields compared with credit yields.
Ahead of the pack is drugmaker Eli Lilly (LLY.N), whose dividend yield of 5.7 percent is 310 basis points higher than that of its average bond yield. Verizon (VZ.N)'s dividend yield is 6.3 percent, 290 bps higher than the bond yield.
In Europe, Zurich Financial ZURN.VX's dividend yield is 6.7 percent while Vodafone (VOD.L) offers above 5 percent.
U.S. equity risk premium stands at a 50-year high near 6 percent, according to JP Morgan's measure. In Europe, equity risk premiums on the DJ STOXX 600 index stands at 13.7 percent, above its 11-year average, according to Reuters data.
U.S. equity income-producing mutual funds attracted a net $1.252 billion of inflows in the first eight months of this year, compared with an outflow of $1.297 billion in the same period last year, according to data from Thomson Reuters.
Fund managers polled by Bank of America Merrill Lynch this month have moved into utilities -- traditionally a sector that pays high dividends. Their underweight position has improved to 11 percent from 27 percent in August.
"Corporate bond yield is falling and the attractiveness of equity dividend yields has become more apparent. (Chasing) dividend yield is a defensive mindset but better than parking in cash," said Gary Baker, equity strategist at BofA Merrill.
The S&P 500 Dividend Aristocrats index .SPDAUDP, tracking large cap firms that have sought to increase dividends every year for at least 25 consecutive years, has risen 8.6 percent this year, compared with the broader S&P 500 index .SPX which gained 2.5 percent.
"We like dividend-paying stocks. The market may be returning to a time in which dividend yields become more important than price to earnings ratios," Linda Duessel, Federated's equity strategist, said in a client note.
And there is more reason to by shares than credit. Any rise in government bond yields will hurt corporate bonds, whose total returns this year have been driven mainly by a fall in absolute yield levels thanks to rallying government bonds.
Investors should be mindful, however, that fluctuations in underlying stock prices can easily wipe out gains from dividend.
Moreover, companies can cancel dividend payments at any time, as happened to BP (BP.L) earlier this year after the Gulf of Mexico oil spill. BP was the top UK dividend payer in 2009.
And there is a tax risk too. U.S. tax on dividends and capital gains will rise next year to as much as 40 percent from the current 15 percent unless Congress acts.
Lombard Odier's calculations show that dividend yields have accounted for 47 percent of total equity returns since 1924.
"Relying solely on dividend yields to invest in equities is ignoring half of the picture. And that omitted half could well be bad enough to wipe out the entire positive yield we were trying to grasp," it said in a note to clients.
"Stripping out the dividend part of the stocks by hedging out the beta with options or other structured products is probably an interesting strategy to consider."
(Editing by Patrick Graham)