Can Shrinking Yields Be a Good Sign?


Over the past year, how many times did you log into your accounts, turn on the TV, or read the newspaper – only to find your interest yield as gone down?

For most people, this can be a disheartening situation since it means less money in your pocket.

But what if it meant the opposite?

The pundits speculate 2010 to be the year of trepidation, on both sides of the fence. Many fearful investors will slowly be re-entering the markets and many fearful companies will be making more strategic movements.

What better way to combat slow growth and safely reacquaint your cash with equities than by investing in stable companies paying healthy dividends.

Ironically, high-yielding dividends seem to have gone “out of style”. But not this season, they are back IN. Before the downturn, why would you settle for paltry 3-5% yields when appreciating stocks were returning many multiples of that.

Of course, the irony comes from the fact that dividends have historically accounted for approximately HALF of the total return.

Usually the argument for dividend stocks combines the “getting paid to wait” component with something about the future growth of the company. But with the bleak outlook, how long can you wait for the potential upside of your investments?

What if you didn’t have to wait for growth and instead capitalized on people’s hunger for reliable returns? Here’s where yield compression comes in. I came across this interesting phrase while reading through a fund’s prospectus.

As the demand for stable returns increases, people could flock to these plump yields. Even though your current yield will be decreasing, your principal investment will now be growing.

This happens because dividend yields are calculated as a ratio to share price. As the price of shares go up, the yield goes down. Providing a simple example, if the yield is halved than the stock has moved 100%.

According to the prospectus, the notion of yield compression was the catalyst for the 1982 bull market in bonds. And although not noted, I bet it contributed to the recent bond run-up. Actually, I know it did because I’ve already read an article about The Big Bond Bubble.

Originally, I planned to discuss a few examples. I picked a few stalwart dividend companies and spent the time looking at the yields over the past year. The time-frame provided a nice, Nike Swoosh curve. What seemed to be the trend was that all the companies have already experienced a 0.50% to 1.0% squash in their yields since their spring lows.

Struggling with how this would all be tied in, my mind started drifting. Reaching for those connections and analogies to give readers that “ah-ha” moment.

Somehow I started thinking about fashion and that led to reflecting on the themes of this site. What I want to accomplish may seem hackneyed, but I don’t want to ebb and flow with the changing investment tides.

The important thing to take from this article is not that you can squeeze out an additional 5% return on a 5% yield, but that classic financial strategies will always come back in style.

Dividends may not be as exciting as the hottest investments, but then again, they probably won’t burn out on you either. Just like frugality is IN this season, the simplest techniques typically never fail and can often be the most rewarding.

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8 Responses
  1. Gotta say FinEngr, it makes NO SENSE to me to buy a 10-yr bond yielding 3.75% when I can put my money in a 7-yr CD at USAA for example, for 4.1%.

    I don’t see inflation for at least another year, if not too.. and therefore, maybe only in 2011 will the Fed start tightening.

    There’s too much slack right now, so I expect cheap money for a while, but just in case I’m wrong, I’m not investing in treasuries!
    .-= Financial Samurai´s last blog ..Marketing Or Manipulation? =-.

    1. Fin Engr

      @ FS

      ?? Didn’t quite understand the comment.

      The post wasn’t advocating fixed income options although I would agree on the 10-yr bond comment given the USAA details.

      Initially I was focusing on the phrase “yield compression”, specifically in relationship to high-yielding dividend stocks.

      Then I switched gears as I realized it seemed to become a “something old is new again” idea for investing.

      Since the main themes are (working backwards from the about page) – achieving financial security through optimization and achieving optimization through education – I want to stay away from any concrete predictions or anything of that sort for now.

      Plus, I’m a “monkey with darts” kind of guy.

  2. Regarding the statement about dividends being worth X of the real return from investing in stocks, I have wondered a few times whether this is actually a reason to buy high yield stocks, as often suggested.

    The reason is that as far as I know, the research doesn’t say it was the high yield dividends that paid up all that return. It could be low yielding fast growers that increase their payout every year and saw price rises to match (though that capital appreciation would then match the income gains… hmmm.. thinking aloud here I admit!)

    1. Fin Engr

      @ Monevator

      Thinking aloud is always welcome – that was kind of how this post was written :)

      Agreed. High yields (by themselves) are not the determining factor since companies may use astronomical, teaser yields to entice investors.

      Generally speaking, it seems to me that the technique is more about the weighing the probabilistic outcome that the company has a: worthwhile enough yield (better than what you could get elsewhere), stable enough payout, and investable (made up word) enough business model other people would be willing to buy into.

      It’s still a tough balance, because you never know what could happen. A good example would be Pfizer (PFE) which, in the past year, had a fair amount of articles written about it being a decent place to park cash.

      It’s yield got around 8%, had a large cash cushion, relatively stable business (except for an expiring patent on Lipitor and pending healthcare legislation), and strong payout history. Until they HALVED it!

  3. The Rat

    If yields are shrinking b/c share prices are generally rising, then yeah, I think its a good sign because we’ve been witnessing yields going down since the market meltdown of last year, particularly in the Canadian economy. If we see an individual stock’s yield go down b/c they reduced their divvy payout significantly (like Manulife Financial) I will avoid investing in something like that like the plague.

    Nice post

    1. Fin Engr

      @ The Rat.

      Right, you always want to verify why a stock’s yield is increasing or decreasing.

      Particular to this scenario, it’s a circular cause/effect. Because the stock prices are depressed, the yields are higher. The high yields attract investors looking for “stable returns”, thus driving the stock price up while depressing the yields.

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