Dividend Growth Stocks and High Yield Bonds: An Innovative Approach to Generating Investment Income

Generating investment income is challenging, especially in the low-yield environment we have been living with for the past decade. We believe that combining dividend growth stocks with an allocation to shorter-duration non-investment grade bonds is an effective solution.

Generating investment income is an age-old challenge that has been particularly difficult recently, as bond yields have been stubbornly low since the Great Financial Crisis. Creating consistent cashflow is a top priority not only for retirees, but also for endowments, foundations, and family offices that need to fund their operations. For many investors (and their advisors), the standard playbook is to increase their fixed income allocation and reduce their equity allocation, creating a reliable cashflow stream and decreasing portfolio volatility.

The downside of this approach is that it makes it harder for portfolios to grow, as investors are spending (rather than reinvesting) the proceeds from their fixed income investments. At the same time, they are dipping into their equity portfolio to cover any shortfalls or unexpected expenses. The combination can result in a portfolio with both declining principal and income potential.

In managing assets for both high-net-worth individuals and institutions for nearly 40 years, we have found that a dividend growth strategy, which invests in the subset of dividend-paying stocks with growing earnings and dividends, combined with an allocation to shorter-term non-investment grade bonds is a compelling solution to this problem. It provides a combination of relatively high current income, future income growth, and capital appreciation, while still limiting volatility.

Dividend-Paying Stocks Are Diverse

Despite its reputation as a haven for antiquated, stodgy companies, the dividend-paying universe is fairly diverse, with over 75% of the S&P 500 paying dividends. Although many dividend-paying stocks fit the traditional stereotype – mature businesses with above-average yields and slow growth rates – there are also plenty of dividend growth stocks – dynamic companies that operate in expanding markets with favorable long-term growth prospects.

We feel that investors with a multi-year time horizon are far better off holding dividend growth stocks than slower growing stocks with a higher dividend payout. In the short run, dividend growth stocks may produce slightly less income, as they generally offer lower payout rates, but over time their faster top-line growth should provide investors with compound returns in both their income stream and their share price appreciation.