Dividend interest income

Is dividend income the new interest income?

Since several years we face the problem that interest rates are falling and falling. This scenario is for borrowers ideal, because they can borrow more money than before, but pay less interest. This means, that their available income is growing, although their liability is growing too. One of the biggest debtor is the government and not only in the United States (over 100% total public debt as percent of gross domestic product) but nearly overall in the world, like in Europe (Greek 182%, Italy 135%, Spain 101%) or Japon (227%). They are the biggest gainer by decreasing interest rates and simultaneously they increase their absolute debt and debt as percent of gross domestic product (see picture).

If you look at the yield of bonds from the United States, you will get approximately 2.5% for USA, (Bond 2.5 15feb2045 30Y,)  at the moment (April 2016). This is not much and as you may know, the United States lost their good rating (AAA) from S&P Rating, though Fitch and Moodys still give them AAA.

As a saver and investor we fight against a very powerful organisation, which wants to hold the interest rates down. Therefore, we have to look for alternative investments, if buying treasuries or bonds do not satisfy our expected return. So we might look to dividends. Some companies pay high dividends compared to interest rates on bonds or treasuries.

Calculation of the dividend yields

To calculate the dividend yield you simply divide the dividend  through the current price of the stock. For example:

Stock price: $ 50 USD
Dividend per share: $ 2 USD
$2 / $50 = 0.04 = 4%

Compared to the 2.5% yield in US Bonds over 50% of the companies, which are listed in the Dow Jones Index offer a yield over 2.5%, partielly up to 4%, like Caterpillar, Verizon or Chevron. But keep in mind, that these numbers can change very fast, because share prices change more than bond price.

Difference between interest and dividend yield

There is one big difference between the yield of a bond / treasury or a share. A bond has a date of martury. At this date the debtor pays 100% of his debt back. (Yes, I know, there are a few bond with indefinite run time.) In contrary shares have an indefinite run time, which means, that you don’t know when and how much of your initial investment you will get back. This makes the comparison very difficult and also the calculation of the yield.

Example:
We will compare a share, here Caterpillar (CAT) with a bond and suppose, that we have taken this investment for 4 years. Furthermore we assume, that Caterpillar will pay the same dividend amount over the investment period.

Caterpillar: 4/4/2016
Share price: $75 USD; Dividend $3.08 USD ==> 3.08/75 = 4.1%

Assumption 1: Caterpillar: 4/4/2020
Share price: $50 USD; Dividend $3.08 USD ==> 3.08/50 = 6.1% and capital loss 75 – 50 = 25, i.e. 33% (50/75=66%)
Calculation: 75 Investment + 4 * 3.08 dividend + 50 Sell price = -12,68; Yield -16.9% (per year: -4.23%)

Assumption 2: Caterpillar: 4/4/2020
Share price: $100 USD; Dividend $3.08 USD ==> 3.08/50 = 6.1% and capital gain 75 – 100 = 25, i.e. 33% (100/75=33%)
Calculation: 75 Investment + 4 * 3.08 dividend + 100 Sell price = $37.32 USD; Yield 49.8% (per year: 12.44%)


Bond: US Treasury 2020 (ISIN US912828J843)
Bond Price: 101.16 Interest: 1.375% ==> 1.375/101.16 = 1.3%

Fact: US Treasury 3/31/2020
Bond Price: 100.00 USD; Interest $1.375 USD ==> 1.375/101.16 = 1.3% and capital loss 101.16 – 100 = 1.16, i.e. 1.15% (100/101.16=98.85%)
Calculation: 101.16 Investment + 4 * 1.375 interest payment + 100 Sell price = $4.34 USD; Yield 4.3% (per year: 1.07%)

Bottom line:

If you buy a bond or treasury, you know in advance your yield, but if you buy a share, you don´t know it, because you don´t know the share price in the future. It can be a very good investment (assumption 2) or a very bad investment (assumption 1).

Is this the end of the story? No, there are a few more points to consider, if you decide to invest.

Increase or decrease of dividend payment?

If you consider investing into a company because of the dividend payment, you should also look at the development of the dividend payment. How much did the company pay in the last years? Did they pay the same amount or, even better, increased the amount? Timeframe

Take a longer look at the history of each company. Did they pay consistent dividends, even in bad years? If they did, you can rather expect, that the company will behave similar in the future. Examples are Caterpillar, AT&T or Nestlé if you look abroad. For instance Proctor & Gamble pay dividends since 1890 and Colgate since 1895.

Sustainability

Take a look at the business model of the company. Is it sustainable or will it change? Companies like Coca Cola or Caterpillar have the same business model since their foundation, but others have to change, for instance the oil companies, who fight with low oil prices, fracking and alternative energy. Even the Rockerfellers, who became very rich through their investment at oil, decide to reduce their investment in Exxon.

Payout ratio

This point is also very important, because it is the part of the profit, which goes to the shareholder. Some companies pay very little or nothing, like Amazon or Blackberry did. They argue, that they need the money for investments, which will grow the company and raise the share price. This is good for the investor, but I think you should decide on your own, especially in this article, which is about dividend yield! On average companies pay roughly between 30% and 50% of the gain to the shareholder.

Share price

DowJones90Years

The image shows you the development of the Dow Jones Industrial Average. Even though the chart goes from World War II to today, it seems to have only one direction – up! This could lead you to the assumption, that an investment in a company which also pays a high dividend, would be a good investment.

Yes, it can be, depending on the business model of the company (see above) and your timeframe. Although the price goes up in general, there are a few parts, where the price decreases for a long time. If you have to sell your investment in this time, which can last several years(!), you will suffer a loss. Therefore you should decide wisely and I recommend diversifying your investment over sectors and countries.

Conclusion

Is dividend income the new interest income? Despite the fact, that share prices can significantly increase and decrease, you should definitely give them a shot. Especially if you take into account, that the indebtedness of the government is already very high (over 100% total public debt as percent of gross domestic product), the rating slowly decreasing and in the long run you can`t be sure, that you will get your money back. Too many countries declared bankrupty over the last years and there is no guarantee, that I will stop in the future.

2 thoughts on “Dividend interest income

  • 8. April 2016 at 18:54
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    Hi Bernd!
    I totally agree with you about investing in government bonds. It is way to risky and I think US government bonds will go much much lower. It’s a bubble.

    I think what you are saying about the interest rates are the most important topic in economics today. We have historically low interest rates now. I mean the FED fund rate is 0-0.25%.

    It’s all good to have all this debt as the government and corporations have today. But once interest rates start going up to normal levels, by inflation forcing the FED to raise interest rates, we are going to see massive amounts of defaults.

    Governments and corporations like your saying have taken on so much risk. Even if the interest rate goes up to 3% the US government will spend almost all of it’s tax income to service the interest on the national debt.

    Is there a specific metric you look at when you invest in dividend for the corporations debt? I’m concerned that every single company will be affected by the coming debt crisis. I’m too afraid to invest in high yielding companies if I believe that they are over leveraged.

    Great article!
    Marcus

    Reply
    • 9. April 2016 at 10:57
      Permalink

      Hello Marcus,
      thanks a lot for your high quality comment. I appreciate your estimation of our economic. You also mention the falling interest rates. For this topic, please check my article “Fed interest rate forecast“. There I discuss in detail my opinion about future interest rate and I would be glad to read your opinion. Thanks.

      Reply

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