Dividend paying stocks tend to outperform when the stock market decreases while paying a stream of income in the form of dividends. There is a reason they are called “widow and orphan” investments. However, these stocks are no longer just suited for the retiree crowd. With interest rates at historic lows, favorable tax treatment, and a volatile market, dividend producing stocks make sense for many investors.
Current economic conditions have lead many experts to recommend dividend paying stocks. The first factor is record low bond yields. 10-year Treasury rates have been consistently below 3% since the end of July. Another option is for an investor to lock money in a five year Certificate of Deposit (CD) with current rates below 2%. These low interest rates on debt securities lead investors to dividend paying stock investments that can yield an average of over 3% while maintaining the ability to move to a fixed income investment if interest rates increase.
First, it is important to understand that income received from CD’s, money market interest, or short-term capital gains are taxed at ordinary income rates. Therefore, an investor in the 28% tax bracket will pay 28% on income earned in these investments. Obviously, this creates a significant tax burden or the other way to look at it is it effectively reduces the net rate of return.
However, ordinary stock dividends are taxed at a lower rate. For individuals in the 15% bracket or lower, they do not have to pay tax on dividends. For those in the 25% tax rate or higher, ordinary dividends will be taxed at 15%. This is a significant advantage to all investors using dividend paying stocks as opposed to interest bearing investments.
Although dividend paying stocks are less volatile than the overall market, an investor in dividend paying stock is still subject to significant volatility. It is not a strategy that should be used by individuals looking to preserve capital.
There are multiple mutual funds, exchange-traded funds, and individual stocks that focus on paying dividends. SPDR S&P Dividend (SDY) is an exchange-traded dividend stock fund with a low internal expense ratio which seeks out companies that have a long track record of paying out dividends with current yields above 3%. (according to Morningstar) Many individual stocks, including Exxon Mobile Corp (XOM), McDonalds (MCD), and Johnson & Johnson (JNJ), have a history of paying dividends.
With the current economic conditions and tax environment, many investors are reconsidering or increasing exposure to dividend paying stocks.