Are High-Yield Stocks Good Bets Following September's Sell-Off?

The S&P 500 slumped to its lowest level in four months after falling 4.7% in September. With the selloff continuing through the first week of October, the stock market index’s year-to-date gain now sits near 12%, down from as much as 21% this summer.

 

Rising bond yields have fueled much of the equity market’s angst. In September, yields on 10-year Treasury notes jumped from 4.2% to 4.8%, hitting their highest level since 2007.

Credit markets are fickle. But as markets increasingly internalize that rates will remain higher for longer, investors can’t help but wonder if the four-decade downward rate cycle has ended for good. Today’s interest rates could be here to stay. Or turn even higher.

Your guess is as good as mine. But the pain has been real across bonds, bond-like stocks – those with relatively high dividend yields and low growth – and companies dependent on raising debt and equity capital to fund expansion.

 

Real estate investment trusts (REITs) check many of these boxes and lost over 7% during September. The utilities sector slumped nearly 6% as well and has been the worst performing part of the market this year.

Higher risk-free yields compete with dividend stocks for investors’ capital.

Using Realty Income (O) as an example, the retail REIT’s dividend yield started the year near 4.5%, above the 3.9% yield available on a 10-year Treasury. With risk-free yields near 5% available today, O’s stock has repriced to offer a competitive dividend yield north of 6%.

Could Realty Income’s valuation get even worse? If interest rates defy expectations and head significantly higher, anything is possible. 

 

For example, in early 2000, when the 10-year Treasury yield exceeded 6.5% (versus 4.8% today), Realty Income’s dividend yield topped 10% (versus 6.1% today).

 

Higher rates also increase a company’s borrowing costs. Realty Income has some near-term insulation since approximately 92% of its debt carries fixed rates, and only 16% of its debt matures through 2025. Coupled with the REIT’s A- credit rating, Realty Income’s balance sheet and debt profile are among the strongest in the sector.

                                                                                             

That said, higher rates can reduce a company’s growth by limiting the pool of profitable investment opportunities. If property prices and cap rates haven’t responded to a REIT’s rising cost of capital, then raising debt and equity to make acquisitions will result in smaller returns or might not be economical at all. As growth prospects fade, valuations contract.

So, should high-yield stocks be avoided in the current environment? While another spike in interest rates is a real risk factor to consider in the near term, many of these stocks are looking interesting.

 

Take the beaten down utilities sector as an example. Investors have shunned this usually defensive space, putting it on pace for its worst year since 2008 as many bonds now provide comparable income with less risk.

 

As a result of the selloff, the median forward P/E ratio across stocks in the utility sector has fallen to 14.4, down from 18.6 at the start of 2019. The current P/E ratio is equivalent to a 6.9% earnings yield (the inverse of the P/E ratio).

 

In other words, every dollar invested at this valuation gives you about 7 cents of earnings generated by a business that essentially acts as a regulated monopoly, provides essential services, maintains an investment-grade credit profile, and seems likely to grow at a low single-digit pace over the long run thanks in part to a shift to cleaner energy.

 

That doesn’t sound like a bad deal for a conservative investor who desires to maintain some exposure to stocks for the long-term capital preservation and income growth they provide. 

 

However, it might not sound so hot if the 10-year Treasury yield blows past 5% or if regulators are very slow to increase utilities’ allowed return in recognition of their higher cost of capital. But those are tough calls to make. Maintaining a diversified portfolio can help protect against company- and industry-specific risks. 

 

Looking ahead, higher borrowing costs, tightening credit conditions, and slowing economic growth create an uncertain outlook for financial markets. This could cause any number of issues down the line, from more stress in the banking sector to solvency concerns for the whopping 50% of all publicly-listed companies that were unprofitable in 2022.

 

Owning great businesses that generate reliable cash flow, provide time-tested products, and maintain prudent balance sheets takes a lot of risk off the table. But when periods of heightened volatility inevitably strike, don’t become part of the club Peter Lynch referred to when we he said that everybody is a long-term investor until the market goes down.

 

“People have been successful investors because they’ve stuck with successful companies. Sooner or later the market mirrors the business.” – Warren Buffett

 

We’ll continue doing our part to help you stay the course, reviewing companies across our Dividend Safety Score coverage universe every week and providing timely information when you need it most. 

We are also spending more time studying companies’ debt schedules and hope to have some helpful analysis to share with our members soon.

Thank you for your reading, and please feel free to register for a trial of Simply Safe Dividends if you are looking for tools and research that can save you time and money overseeing your dividend portfolio.

Sincerely,

Brian Bollinger
President & Analyst, Simply Safe Dividends