With the Federal Reserve likely to cut interest rates at its September meeting, dividend-paying stocks are becoming an attractive choice for income-focused investors. The CME FedWatch Tool shows that a rate cut from the current range of 5.25% to 5.5% is highly likely, signaling a change in investment strategies. This expected shift could greatly affect those who have been relying on money market funds, which currently offer yields over 5%. As interest rates fall, these yields will likely decrease, leading investors to look for alternative income sources.
Stephen Tuckwood, Director of Investments at Modern Wealth Management, points out the rising appeal of dividend-paying stocks in a lower interest rate environment. He suggests that as the risk-free rate drops, dividend-paying stocks could become a key income source for investors. Despite the overall market’s strong performance in 2024, with the S&P 500 up nearly 19%, dividend-focused stocks have lagged behind, as shown by the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which has returned 10.1% year-to-date. This gap offers investors a chance to benefit from a possible rebound in these stocks.
However, Tuckwood and other experts advise investors to be careful when choosing dividend-paying stocks. High dividend yields can sometimes be deceptive, indicating potential risks within a company. Rick Wedell, Chief Investment Officer at RFG Advisory, warns that unusually high yields might signal financial trouble or a sharp drop in share price, which could lead to dividend cuts, especially in an economic downturn. Chris Senyek, Chief Investment Strategist at Wolfe Research, agrees, noting that companies with the highest yields often experience slower growth and face a higher risk of reducing dividends later in the economic cycle.
To avoid these risks, Senyek’s team suggests focusing on companies in the second quintile of dividend yields, which usually offer a more balanced risk-reward profile. Examples include Texas Instruments, which has risen 23% in 2024 and offers a 2.5% dividend yield, and Kroger, which is up 15% this year with a 2.4% yield. These companies show strong performance while maintaining sustainable dividend payouts, making them safer choices for income-seeking investors.
When evaluating dividend-paying stocks, Tuckwood emphasizes the importance of looking at a company’s earnings quality, balance sheet strength, and free cash flow, as these factors are key to sustaining dividend payments. Additionally, the management team’s commitment to maintaining dividends is crucial, as dividends are often one of the first expenses to be cut during economic challenges.
Investors should also be aware of the need for portfolio diversification, as focusing too much on dividend-paying stocks, especially in sectors like utilities and consumer staples, could create imbalances and hurt overall portfolio performance compared to broader market indices like the S&P 500.
For a more straightforward approach, investors might consider exchange-traded funds (ETFs) focused on dividend-paying stocks. However, Daniel Sotiroff, Senior Manager Research Analyst at Morningstar, advises caution even with ETFs, as they can include companies that seem appealing due to high yields but may have underlying weaknesses. He points out the underperformance of high dividend yield ETFs during the COVID-19 market downturn when funds heavily invested in energy stocks struggled as oil prices collapsed.
Sotiroff recommends a balanced approach, suggesting the Vanguard High Dividend Yield ETF (VYM) as a smart choice. With a total return of about 14% in 2024 and a low expense ratio of 0.06%, VYM offers a cost-effective way to gain exposure to dividend-paying stocks without taking on too much risk. As the Federal Reserve’s expected rate cuts draw closer, dividend-paying stocks present a promising option for income-seeking investors. However, careful selection, diversification, and an awareness of potential risks are key to successfully navigating this investment strategy.
Comments