Are you disappointed that banks will not pay decent rates on CD’s anymore? Does the stock market bubble scare you? If you could put your money in a 7.3% CD, would you do it?
A 7.3% CD would be a dream come true for many people, but would it intrigue you to know that from an investor’s perspective, a dividend can be a far better investment than a CD ever was?
First, let me say I am not writing this article to try to become an investment advisor or manager. My reason is to take a break from writing on legal topics and mix things up a bit. Nothing that follows is legal or investment advice. You’re on your own. Take it for what it’s worth and consult your investment advisor.
Why did CD Rates Fall?
Does anyone remember the “good, old” days when CD’s paid 5% and more? In those good, old days, people were also paying 8%+ interest to purchase their homes and 10%+ to buy cars.
The power of the Fed is practically unfettered. It can change the direction of the entire economy with the twist of a knob. Uncle Sam loves homeowners and wants people to be able to afford a reliable car to get to work. All of this translates into more taxable income to the government.
Over the last couple of decades, we’ve witnessed the plan in action. Interest rates have dropped, time and again, to today’s all-time lows. When it comes to CD’s, banks are in the business of lending, not borrowing.
A CD is the bank’s way of borrowing in order to turn around and loan the borrowed money to a consumer at a higher interest rate. It earns profit on the spread. A banks is not going to pay 5% on CD’s and lend you the money back at 2.8%. That would put the “bank” in “bankruptcy.” (pun intended)
Recently, the Fed announced that we should not expect interest rates to rise anytime soon. So, don’t expect CD rates to rise, either.
Annuities
An annuity is a stream of future payments. Think of it like a weekly allowance. If we could, we would all like to set a weekly allowance and know we will get it the rest of our lives. Wouldn’t that be perfect? The problem is you can’t find too many savvy people making financial promises that last forever.
If I promise you an allowance of $20 per week for the next 5 years, you own an annuity.
In the financial sector, annuities are purchased and sold all the time – just like people buy and sell gold, stocks, etc.
Using the example from above, you now own a 5 year annuity. How much can you get for it if you want to sell it now for cash?
It’s $20 * 52 weeks * 5 years = $5,200 in payments, but they are spread out over the future. That annuity will be worth less than $5,200 today. Maybe $4,500 if the maker of the promise (that’s me) is a good keeper of its promises. Maybe $2,000 if the maker is not so reliable. Let’s say I’m reliable, and the odds are very high I will pay the $20 per week. Your annuity is worth $4,500.
Suppose I upped my offer. I will now offer to pay you $20 per week for the next 10 years. This will definitely add more value to your annuity. You could sell it for almost double the price – maybe $7,500. The reason it’s not doubled is because $20 paid 10 years from now isn’t going to be as good as $20 paid 5 years from now. There is a time-decay factor in the value.
CD’s and other annuity-like investments typically have limited time periods. They expire in 1 year, 3 years, 5 years, etc. Upon expiration, the banks can take a look at current interest rates and modify the new offerings. As you can see, the banking and lending sector is all interest rate driven.
When interest rates are really high, CD owners laugh at corporate shareholders who earn their measly dividends. When interest rates are low, the shoe is on the other foot.
Moreover, a solid dividend does not fluctuate as interest rates change. Nor does it fluctuate when stock prices change. You can pass it down to your kids, and they can pass it along to their grandkids. In theory, the dividend can be forever. Think of it as an annuity in perpetuity.
There is an extremely simple formula used to determine today’s value of an annuity in perpetuity: Price / Yield.
Let’s use a simpler annuity so that we can show quickly how this formula works. Assume an annuity which pays $10,000 per year in perpetuity. Let’s say I am a buyer of annuities and I like to earn 7% on my money. I don’t want to take stock market risks, where returns are up and down all the time. I would be happy just to get 7% for the rest of my life.
For the $10,000 annuity in perpetuity, I will pay $10,000 / .07 = $142,857.14.
Dividends – What they are
Dividends are sums of cash which corporations might pay to their shareholders from time to time. There is not a law requiring any company to pay dividends. Companies choose to pay dividends as a matter of internal policy, which is voted on by their boards of directors.
For example, newer, growth-oriented companies tend not to pay dividends. This is because they are trying to grow. They need all their cash to invest in growth. Rather than looking for dividend income, shareholders in these growth companies are hoping the stock prices quickly double, triple or quadruple. It can be very lucrative in a short amount of time, but the catch is that it is risky, too. What if the company’s management makes a wrong decision with the cash? For example, what if management uses the company’s cash and combines it with debt to buy a competitor at a high price, only to be run out of business a year later by a different competitor which offers better products or services? Ughhh! It happens.
Now, let’s contrast growth stocks with cash cow stocks. There are very old, well-established businesses that have been around for over 100 years. They aren’t trying to grow by leaps and bounds. Those days are mostly over, even though they still try to retain their market share as much as possible. These are huge companies that make a lot of money.
Take AT&T, for example. It’s ticker symbol is T. It’s a cash cow. It tries to keep up by innovating into different segments. It has moved into wireless service, for example. It also bought HBO and Time Warner, among other things.
You can look at all kinds of information on T’s stock from many sources all over the internet, including here. However, you might want to keep reading a bit before clicking the link.
Where does T’s money go since it doesn’t need all of it for growth? To the shareholders, of course! The money T pays to its shareholders is called “dividends.”
Stability of Dividends
Remember, just because a company pays dividends does not mean that you have a legal right to depend on those dividends. There are many companies which pay dividends sporadically and in varying amounts. You can’t count on them.
On the other hand, there are also companies that pay very stable, predictable dividends. You can count on them like clockwork. T is one. To the extent T can be counted on for many years to come, its dividends operate much more like an annuity in perpetuity. Remember our super, simple formula from above? We’re going to use it to figure out what T’s dividends are worth. (You will be able to use this same method on any other stock you want.)
Understanding Yield
Before we jump into specifics, it’s a good idea to get the simple concept of yield across in a way that is clearly understandable. Yield is the rate of return that the shareholder receives from dividends. Yield is just stock-speak for “interest rate.”
Laypersons use these terms interchangeably, making it possibly confusing. The better approach is probably to think of it like this: Lenders earn yields, and borrowers pay interest. The rest of what follows discusses this investing topic in terms of yield – so you can take a look at it as if you are in the position of being a banker, not a debtor.
When you look at a stock’s overview on the internet, you will see a section providing a short snippet which says how much dividend the stock pays and what its effective yield is. For example, a notation might state: $2.08 (7.265%). The $2.08 is the dividend, and the 7.265% is its yield. Be aware that some sites show you the annual dividend, and others show you the quarterly dividend. So, if you see $0.52 for T, you now know why.
Remember our super, simple formula? Let’s use it to figure the stock’s price. “Say what?,” some of you might ask. How can I tell you the stock’s price with this information? Here it is again: $2.08 / .07265 = $28.63. The stock is selling for $28.63.
It so happens T’s current price is $28.63 per share. It currently pays $0.52 in dividends every quarter (3 months) for each share. For the $28.63 I paid, I will receive (at least) $2.08 per year in dividend income for as long as I continue to own the stock.
T’s yield is therefore $2.08 / $28.63 = 7.265%. With one minor exception, I’ll just round it to 7.3% from here forward.
What this means is that so long as you continue to receive $2.08 from T each year on your original $28.63 invested, it’s the same as putting your money into a bank CD which pays 7.3% interest forever! These days, that’s a heckuva good CD! You will not find one, though.
Yield is Locked-in Permanently When You Buy the Stock
As stated above, CD’s are usually for a limited duration – usually 1 to 2 years. Take a look at today’s crappy rates here. Is that a joke or what?
T’s dividends, on the other hand, are for as long as it continues to pay them and as long as you continue to own the stock. It’s kind of like buying a 7.3% CD that lasts as long as you want, rather than a CD that expires and has to be replaced every other year with a possibly lower rate.
T is on the prestigious list of “Dividend Aristocrats.” A dividend aristocrat is a large company which has increased its dividend payment for at least 25 consecutive years. You can see the list here.
T has increased its dividend each year for 37 consecutive years. See here. That’s more stable than most banks, many of which have come and gone.
In 2021, T’s dividend is $2.08 per share. Being a dividend aristocrat, T’s dividend will go up in 2022, and we should expect it to increase every year thereafter.
Of course, T’s fortune could change at any time. Life is full of surprises, and there are no certainties, except for taxes and death. Anyway, each person must weigh risks using his or her own judgment. I am very confident in T, but you don’t have to be.
T’s Stock Price could Drop when this Bubble Pops!
It could. However, if you fully understand yield, your response might likely be, “So what?” If you don’t get what I say in the remainder of this section, go back and read the previous section again.
As stated above, in order to maintain its noble title of aristocrat, T will pay $2.08 per share this year. It will pay more than that next year. In 2023, it will pay even more. That’s what it means to be a dividend aristocrat.
If T’s stock falls from $28.63 down to $20.00 next year, will the dividend be reduced or possibly eliminated? Nope! T is on the elite list. It will suspend or reduce dividends only over its dead body. It will borrow to pay dividends if it has to. The only way that dividends will be reduced is if T is on its deathbed. If it doesn’t raise dividends, it will be off the Dividend Aristocrat list for at least the next 25 years! Suffice it to say that being a dividend aristocrat is a very elite status which none of the few honorees wants to lose. They must continuously raise dividends every year to stay on this honor roll.
However, if at anytime you see signs that T is going to go on life support, you are always free to sell your T stock and cash out. Or perhaps future Fed policy lands us back in the good, old days where borrowers were paying 11% to buy a car. Then, and only then, might you be thinking T’s measly 7.3% isn’t cutting it anymore. Then, and only then, might you want to seriously consider going back into CD’s. Until then, we remain way down here at the interest rate bottom and with no growth in sight.
More importantly, until those 11% interest rates return, investors can look to T as a hedge against the stock market, just like CD’s used to be a common hedge against the stock market. It’s a great irony because T is, indeed, a stock. But you are not hedging against dividends (annuities), you are hedging against a decline in stock prices. T is a dividend stock, not a growth stock.
Here’s how it works: You buy T today for $28.63. You get $2.08 in dividend this year. That’s 7.265%. Let’s say you get $2.10 next year. That’s 7.334%. So, actually, your yield will increase as the years pass. That’s even better than being fixed and stagnate. A little growth to help cover for inflation. I don’t recall CD’s ever doing that.
Let’s say in 2026, T stock is going for $32.00 per share and is paying $2.14 in dividend. Then, the stock market crashes. Suppose T’s stock price drops to $25.00 – that’s even less than the $28.63 you paid in 2021. 5 years of stock growth was just wiped out. The value went down to $25.00. You’re thinking, “I’ve lost $3.63 per share. How awful!”
Nope! Not awful. You don’t “lose” unless you sell the stock. As long as you hold the stock, you will get your 2026 dividend of $2.14, and in 2027, you will get even more in dividend.
Let’s say in 2027, you get $2.15 in dividend. That’s $2.15 on the original $28.63 you paid. $7.509%! What a solid source of income! The stock market is down 30%, and everyone is trying to play catch-up. Meanwhile, you just keep right on rocking. “The check is in the mail, and it keeps getting bigger every year!”
In summary, when you buy a share of T stock, your minimum yield on that investment is fixed for life at the moment of purchase, unless something catastrophic happens later.
Of course, the converse is true, too. If the stock price rises to $35.00, your yield will not go up any faster. You will get the same $2.14 in 2026, whether the stock is at $25.00 or $35.00. You can sell the stock and reap the profit, but you will have to give up your 7.3% yield to do it (since you will no longer receive T dividends).
If you buy more T later, the money you invest in those new shares will have a different yield. If you buy T for $33.00 at any point in the future, your yield on those shares will be only 6.3%.
Naturally, some of you might be thinking, “Now is the time to get in and secure my yield before the stock price rises.” This is 100% true. Conversely, if T’s price falls, its yield will rise. If T goes to $25.00 in late 2021, you can get some shares with a yield of 8.3%, which will rise gradually over the years. Nice!
T’s Stock Price should be Less Volatile than the Rest of the Market
Let’s say you buy T today for $28.63, and the entire market crashes, falling 30% the following week. How rotten can your luck be, right?
Will it be likely that T’s price will also drop 30%?
No. If T drops 30% from $28.63 to $20.04, the yield on new purchases will be $2.08 / $20.00 = 10.4%!
10.4%! That would be a heckuva, heckuva yield. Can you imagine a CD paying 10.4%+ for life? OMG!!! Tell all your friends!
A large segment of the investing public is seeking stable returns. As people age, they tend to become more risk averse and want to get away from risky stocks. They need a predictable source of income.
However, don’t let risk aversion imply in any way that risk averse investors are any less greedy than anyone else. If a risk averse investor can find a way to fix a 50% return, he’ll eagerly sign up for it. CD’s suck right now!
So what does this mean? It means that as the market crashes, people will be looking for the best stable returns they can find. The party’s over. Now, they will run to cash, to gold, to real estate, etc. Many will also run to safer stocks, like T, where they can count on a strong yield while everyone waits for the market to recover (whenever that might happen). Sitting in cash will hardly earn you a nickel, but T will earn you 7.3%, no matter what its stock price is.
When a lot of people want to buy T, the price goes up, not down. When everything is crashing around you, a 7.3% yield starts to look good really fast. In fact, people fleeing to safer stocks will want to get to them as quickly as possible. “Get in at 7.3% before the price goes up and the yield falls!”
For this reason (which I hope I stated clearly), T’s stock will resist a market collapse. Is T immune from a crash? I won’t go so far as to suggest it is immune, but you can certainly see why its price will tend to be more stable (and even possibly rise) as the market crashes.
It is possible that in times of panic, T’s stock will fall because untrained shareholders don’t understand everything I’ve covered above. They will just panic and tell their investment advisors, “Cash it all out! Everything! Out!”
No! Don’t do that! Why would you give up your fixed 7.3% yield when the market crashes? That’s the dumbest move you can make. Nevertheless, there could be plenty of people who don’t understand these concepts and who simply panic and throw out the baby with the bath water.
If panic forces T stock substantially lower, you now know what this means. It’s a bargain shopper’s paradise!
If the public is really dumb enough to force T’s price to $20.00 (yielding 10.4%), you need to be ready to buy if possible. Hopefully, you have the cash to be able to do it. Those new T shares at $20 will be a steal!
T’s Yield History / What this could Mean for Its Future Price
Word to the wise. T’s yield could be in a bubble.
This article’s featured photo shows you T’s dividend yield graph since 2000. You will see that it has always been between 5.2% and 7.3%. Guess what? It is 7.3% now, and it never has been this high before.
Check out T’s price graph, just above it’s yield graph. If you study it, you will see that the price line and the yield line are almost mirror images. Price goes up; yield goes down. Price goes down; yield goes up.
The most perplexing thing about this is that T’s stock could be in a yield bubble while most other stocks are in a price bubble.
T’s yield is at an all-time high, but T’s price is nowhere near its record. Why is that? Well, for one thing, the DJIA, S&P 500 and NASDAQ have been on fire the last few years. These people are in the big game, making 15%, 30% and 200% per year. This is why many people fear that we’re in a bubble!
Think back through everything you’ve just read and answer this: What must happen for T’s yield to fall from its current high of 7.3%?
Naturally, it’s price must rise – not fall. If you feel that T’s record-setting yield must fall sooner or later, the value of your T shares must go up. That’s a really, really good thing for people who already have lots of T and don’t need to, or can’t, buy any more of it. It’s especially good if these people have to sell some shares to pay some bills, buy a new car, etc. It’s always better to cash out when prices are high and yields are low.
On the other hand, record-high yields can be strong incentives for people to get in before they fall. Suppose T’s yield heads back to the middle of its historical range of 5.2% – 7.3%. Based on its current $2.08 dividend, T’s price would have to rise to $34.67 ($2.08 / .06) in order to yield 6%. That’s a 21% gain in price to the person who buys T today!
Knowing that the dividend will be higher in a few years, let’s say the retreat to a 6% yield finishes a few years from now, when its dividend is say, $2.13. The price at that time would be $2.13 / .06 = $35.50. That’s a 24% gain in stock price.
For the person who waited and didn’t buy T today, he missed a chance to get in at 76% of the then-current price.
People who feel bearish on the market (fearing a bubble) are leaving their money in stocks because they think CD’s are the only alternative. They think the choice is between insanely high yields and insanely low yields. As shown, reasonable returns are there for the taking in good dividend stocks.
T appears to be a really great deal for a solid, dependable return. At a 7.3% yield, it looks to be the best deal it’s ever been and a fantastic hedge against a future market collapse.
The Yield-Growth is a Bonus
In T’s yield history, you will see that the chart in the middle is the dividend pay-out chart. Let’s now see what life would be like today for a person who bought T in 2000.
First, he bought the stock for about $15.36 per share. It’s dividend at that time was $0.36. This provides a yield of $.036/$15.36 = 2.34%. Not too appealing.
Fast-forward to today, and each share of T is now paying $2.08 in dividend. Remember, the original investment in the share was only $15.36. What kind of return is $2.08 giving him on his original investment? It’s $2.08/$15.36 = 13.54%! Now you know why many families keep T stock in the family and pass it down with instructions to their kids never to sell it.