By Philip van Doorn, MarketWatch
As junk-bond investors have suffered acute pain heading into the Federal Reserve’s decision to increase interest rates Wednesday, dividend-stock investors can take solace because they will probably be affected to a much lesser degree.
Large-cap stocks with solid long-term dividend track records tend to outperform the broader market, no matter the interest-rate environment.
When interest rates rise, bond prices fall so that existing bond yields will match the yields of newly issued bonds (with similar ratings) with higher interest rates. The higher the yield, the more the bond will decline in value when rates rise, and increase in value when rates drop.
But that doesn’t necessarily hold true for stocks with attractive dividend yields, since companies may still be growing their businesses or have plenty of cash flow to support increasing dividends. It’s also quite likely that the Fed will take a slow-and-steady pace in lifting interest rates. The federal funds rate was been locked in a range of zero to 0.25% from late 2008 until today, when the target range was lifted to 0.25% to 0.50%. Chances are, interest rates probably will still be near record lows a year from now.
Then again, if the U.S. economy keeps growing at its current modest pace (the median estimate among FOMC members and regional Federal Reserve Bank presidents is 2.1% for 2015), the Fed projects the federal funds rate may range from 2.9% to 3.9% in 2018 . The central bank clearly wants to regain effective use of its main policy tool, so that lowering rates when the next recession eventually hits, can be effective. This means a likely long-term upswing in interest rates.
If you are selecting dividend stocks, you will want to be careful to consider how likely a company may be to cut its dividend, which can be an absolute killer for the share price. The market often “prices in” anticipated dividend cuts, as we have seen this year in the energy and materials sectors. The brutal environment for commodities has affected companies in other sectors, such as construction-equipment maker Caterpillar Inc. /zigman2/quotes/203434128/composite CAT +0.51% . The stock is down 27% this year, pushing its dividend yield up to 4.61%. No one can predict whether Caterpillar will cut its dividend, especially since the company bought back $1.5 billion in common shares during the third quarter, even though it is in the midst of a major restructuring.
One way to gauge a company’s ability to raise dividends, or at least not cut them, is to divide its free cash flow per share by the share price to come up with a free cash flow yield. And that can be compared with the dividend yield. A company’s free cash flow is its remaining cash flow after capital expenditures.
To present a useful list of dividend stocks with dividend yields that appear safe, we started with the S&P 500, and then removed stocks with negative returns of 15% or more this year. After all, investors have little confidence in them.
We then pared the list to companies that have paid dividends for at least five years, while removing any that have cut regular dividends at any time over the past five years, according to FactSet.
Here are the 10 remaining S&P 500 stocks with the highest yields, as well as “headroom” to raise or maintain dividends:
|Company||Ticker||Industry||Free cash flow yield - past 12 months||Dividend yield||‘Headroom’|
|HCP Inc.||HCP||Real Estate Investment Trusts||8.72%||6.23%||2.48%|
|Mattel Inc.||/zigman2/quotes/209819189/composite MAT||Recreational Products||5.99%||5.61%||0.38%|
|AT&T Inc.||/zigman2/quotes/203165245/composite T||Telecommunications||7.01%||5.56%||1.45%|
|Welltower Inc.||Real Estate Investment Trusts||6.62%||5.11%||1.52%|
|Verizon Communications Inc.||/zigman2/quotes/204980236/composite VZ||Telecommunications||10.12%||4.96%||5.16%|
|Philip Morris International Inc.||/zigman2/quotes/201611010/composite PM||Tobacco||4.68%||4.64%||0.03%|
|Realty Income Corp.||/zigman2/quotes/200487782/composite O||Real Estate Investment Trusts||5.40%||4.58%||0.82%|
|People’s United Financial Inc.||/zigman2/quotes/200304796/composite PBCT||Savings Banks||4.89%||4.11%||0.78%|
|Kimco Realty Corp.||/zigman2/quotes/202836571/composite KIM||Real Estate Investment Trusts||6.15%||3.94%||2.20%|
|Altria Group Inc.||/zigman2/quotes/208895754/composite MO||Tobacco||4.88%||3.94%||0.94%|
For real estate investment trusts, we used funds from operations instead of free cash flow, because FFO is generally considered to be the best measure of a REIT’s dividend-paying ability.
Since REITs are primarily income plays, one might expect their prices to drop in a way similar to bonds when interest rates rise. But the REITs listed here all invest in income-producing properties, with the goal of increasing FFO and dividends. If their strategies are executed well, these may be excellent plays, as long as your objective is income and you can bear volatility while staying committed for the long term. Besides, if former Federal Reserve Chairman Ben Bernanke is correct, we’re likely to remain in a relatively low interest-rate environment for years to come.
Verizon Communications Inc. /zigman2/quotes/204980236/composite VZ +1.36% is an interesting dividend stock, as it has the highest “headroom” on the list, based on the past 12 months’ free cash flow.