Bond yields have risen in recent months from historic lows, but by any objective measure, we’re still in a low-yield world. This means that many investors, especially income-oriented ones, continue to ask: “Where can I find income?”
While equities are not nearly as cheap as they were a year ago, they are still a reasonable answer to the question. Consider the following:
1. Even after the recent rise in yields, bonds are still expensive. A key measure of the fair value of bonds is their real yield, i.e. their return after factoring in a reasonable expectation for inflation. Today, real yields are still artificially low thanks to help from central bankers. As of the end of July, the yield on the 10-year Treasury Inflation Protected Security (TIP) – a good proxy for real rates – was 0.37%. By comparison, the fifteen-year average of the 10-year TIP yield is roughly 2.2%.
2. While the 2013 equity rally has driven up valuations, stocks still look attractive as a source of income relative to fixed income alternatives. A simple exercise illustrates this. Today investors can replicate roughly 50% of the income generated by an investment grade bond index with the dividend stream from a broad, global equity index. While this is down substantially from last November’s all-time high of 62%, it is still well above the long-term average of 32%. In other words, stocks are no longer that cheap, but they still look inexpensive compared to bonds.
But though equities still look reasonably priced in the aggregate, not all corners of the equity market look equally attractive as options for income-oriented investors. Many of the traditional yield plays – such as the utility and REITs sectors – look stretched. As such, investors may want to avoid these sectors and instead focus on three alternatives:
1. International dividend payers. Today, the yield on the Dow Jones EPAC Select Dividend Index is slightly less than 5%. This compares favorably to the sub-2% yield on the S&P 500 and a yield of 3% to 3.5% for US dividend indices. In addition, the income on international dividend payers comes at a much lower price than the income of US counterparts thanks to stretched valuations for many domestic dividend plays. Currently, average valuations on US dividend indices are north of 18x earnings as compared with 15x earnings for indices of international dividend payers. While investors are taking more risk with the international funds, notably currency risk, I believe prices already reflect this risk. Finally, while international dividend stocks have been trailing the broader market for much of the year, their performance has picked up dramatically over the past month.