SCH: Charles Schwab: Dividend Income

Now that the Fed has lowered rates yet again, let's explore dividend strategies for investors seeking current portfolio income in a low-rate environment.

Whether or not you find yourself with more bonds in your portfolio than you’d like, highly rated stocks paying solid, “qualified” dividends might deserve a closer look for your taxable accounts in light of the new tax law. Why? If you’re in the 33 percent federal income tax bracket or higher, you’ll keep only two-thirds or less of your taxable bond coupon. But 85 percent of your qualified dividends will find their way into your after-tax pocket.

Here's how some average market interest rates¹ compare to various hypothetical dividend yields as of this writing, in order from lowest to highest based on federal after-tax yields.

Interest rates vs. dividend yields

Of course, stocks aren’t bonds—what about risk?

• With interest rates at, or at least approaching, what many might consider a long-term nadir—and the possibility of rising rates in the future—you have to ask yourself which asset has the greater potential to rise in value vs. go down in value over the next five years: a diversified group of highly rated stocks of low to average volatility that pay qualified dividends, or a 5-year note currently paying close to 2 percent? Remember, when interest rates rise, bond prices fall.
• You can log in to Schwab’s Stock Screener to select dividend-paying stocks that fit your goals and circumstances. For example, we found 31 stocks (as of June 25, 2003) using the following simple criteria (you’ll likely want to dig a little deeper):
• Stocks rated “B” or higher by Schwab Equity Ratings
• Stocks with a beta, or volatility, of “0 to 1.0” (a beta of 1.0 equals “the market” as a whole)
• Stocks with a dividend yield of “4% or more”
• The advice “don’t chase yield” applies as much to dividend-paying stocks as it does to bonds. As the yield gets north of 5 percent (vs. the current broad market dividend yield of around 1.6 percent), your concern should be rising as well. The dividend yield for a particular company could be abnormally high because of a depressed stock price, and that price might be depressed for a reason. You should evaluate the company in light of the potential for its stock to rise as well as the company’s ability to maintain its dividend.

  For example, you can see below that the percentage of A- and B-rated stocks relative to the total number of stocks in our dividend screens drops significantly as the dividend yield rises (which suggests that a high dividend yield and a high stock rating don’t usually go hand-in-hand).

As always, evaluate any changes to your portfolio within the context of your specific circumstances and long-term asset allocation. Consider your unique goals, objectives and ability to tolerate risk before you take action. And get some help if you need it. Happy dividend hunting!