Dividend Yield Higher Than Bond Yields... Not A Good Omen

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There was a time when investors demanded that equities yield more than bonds. The logic was that bonds were safer and, thus, should return less. Stocks, meanwhile, were riskier and should return more. The notion of capital appreciation killed that logic in the late 1950s.

However, stock yields are now higher than bond yields for the second time in about five years. Does this mean that stocks are undervalued? Maybe, maybe not, but either way there are still high-yielding companies worth looking at, like Royal Dutch Shell (NYSE: RDS-B), Omega Healthcare Investors (NYSE: OHI), Darden Restaurants (NYSE: DRI), and Gold Fields (NYSE: GFI).

The Way Things Were

Before the late 1950s, stocks were seen as a risky asset class. The dividend was viewed as the return on that asset class. Bonds were considered a safe asset class and the yield was, like stocks, the return. Since investors buying stocks were taking on added risk, they demanded more in return. This meant that stocks yielded more than bonds.

Today, the dividend yield is only one part of the return on stocks. The other, capital appreciation, is often considered the more important component. That is, in effect, where the biggest payoff for taking on risk comes from. This view started to take hold in the late 1950s and snowballed into the technology bubble of late 1990s. At that point, companies didn't even need earnings, much less a dividend, to be afforded astronomical valuations.

Back to “Normal”

Interestingly, after the financial-led recession of 2007 to 2009 and the related market crash, dividend yields on stocks again exceeded bond yields. In early December 2008, MarketWatch's Mark Hulbert wrote that, “...the S&P's dividend yield was 3.3%, while the 10-year T-Note was yielding 2.7%—a spread of 0.6 percentage points in favor of stocks. To put this in historical context, the spread since 1958 has averaged 3.7 percentage points in favor of bonds.”

Interestingly, late 2008 was about the same time the market turned upward again. Now, thousands of points on the Dow 30 higher, it is clear that the inflection point was a great buying opportunity.

After that brief period at the nadir of the bear market, the dividend yield on stocks decreased below the yield available on bonds. However, the market is again at a point where the relationship is reversed back to the “normal” seen prior to the late 1950s.

Bloomberg recently noted: “The 1,610 stocks in the MSCI World Index paid an average 2.7 percent of their share price in dividends as of last week, according to data compiled by Bloomberg. That compares with the 2.6 percent yield on the Bank of America Merrill Lynch Global Corporate Index of 10,034 investment-grade bonds...”

To some this may seem like an indication that stocks may again be undervalued relative to bonds, or, at least, that stocks may have more room to rise.

Not so Fast

It is actually quite hard to compare the two periods because of the extraordinary Federal Reserve interventions that have taken place over the last five years or so. QE1, QE2, QE Infinity, and a promise to hold interest rates down for years into the future have all created a backdrop around which “normal” relationships make little sense.

Tellingly, later in the Bloomberg article, it was highlighted that: “the dividend yield on the MSCI World averaged 2.1 percent between 1997 and the collapse of Lehman Brothers Holdings Inc. in September 2008, according to Bloomberg data. That compares with the 5 percent average yield paid by the Bank of America global corporate debt index...”

Comparing the two Bloomberg-referenced periods reveals the true nature of today's yield relationship. The yield on stocks increased 0.6 percentage points, which makes complete sense, since the stock market hasn't actually gone anywhere for a decade or more, while dividend payments have continued to increase at many companies.

The bond yield, meanwhile, has actually fallen by nearly 50%. Since bond prices go in the inverse direction as yields, and yields are being artificially held down by the Federal Reserve, the difference is about bond values going up, not stock prices going down. This is pretty much the exact opposite of the brief reversal noted by Hulbert.

So Stocks are Expensive?

There are some who believe that stocks are ripe for a correction, perhaps a notable one. However, that doesn't mean investors can just sit on the sidelines, particularly if you are looking to dividends to help fund your retirement. With the uncertain backdrop, prudently selecting stocks is pretty much a requirement. Some higher-yielding stocks worth considering are:

Royal Dutch Shell

Royal Dutch Shell is an oil giant located in a financially weak region. The biggest issue dragging on the stock, however, is an aggressive move into natural gas. Although this energy source appears to have great potential, low gas prices in the United States are a massive obstacle that only time, and a return to a more normal price/supply equilibrium, can heal.

Shell's yield of over 5% is more than double that of industry heavyweight and Dow-30 component Exxon Mobil, despite their overall similarities, which suggests Shell might be a good way to gain exposure to hard assets that will continue to be in demand for years regardless of the uncertainty in the world. And you'll get paid to wait for the dust to settle.

Omega Healthcare Investors

Omega Healthcare Investors is a real estate investment trust that focuses on skilled nursing facilities. It owns or holds mortgages on over 450 skilled nursing facilities, assisted living facilities, and other “specialty hospitals” across 33 states. It works with nearly 50 different operators.

Omega's business has been relatively stable, allowing it the distinction of increasing its dividend every year through the 2007 to 2009 recession. That's impressive given that some of the largest REITs, such as mall owner Simon Property Group, were forced to trim or eliminate dividends.

Management is fairly conservative, which is a nice benefit for risk-averse investors. The shares recently yielded almost 7%. With the aging of the baby boomers, Omega's properties are going to be in demand no matter what bond yields and stock yields do.

Darden Restaurants

Darden Restaurants is a leader in the so-called casual dining segment. Its concepts include such ubiquitous brands as Olive Garden and Red Lobster. In addition to these largely mature businesses, the company also owns Long Horn Steakhouse and a collection of higher-end specialty eateries, like The Capital Grill and recently acquired Yard House. These brands still appear to have years of growth ahead of them in the United States.

Weak results from the company's Olive Garden brand have been a drag on the shares, leading to a more than 4% yield. That said, while economic vagaries will definitely impact the company's results, it is one of the best companies in the casual dining space. And the long-term trend toward eating out more often isn't likely to change unless the trend toward two-earner families suddenly reverses. Add in the fact that Darden has little in the way of foreign operations, and you can see where it might have years of growth ahead of it.

Gold Fields

Gold Fields is among the largest gold miners in the world, with a heavy concentration on South African assets. Its production costs tend to be on the high end of the industry, though, which is a negative. However, it has material reserves, which helps to ensure its long-term viability. It is also working on expanding production at key mines, which should help keep costs in check. This isn't a stock for the feint of heart, since gold stocks can be quite volatile. However, gold is a hard asset that has historically provided some protection during difficult times. For income investors looking for the “hardest” of hard assets, this stock's 3%-plus dividend yield might be an interesting way to find some shelter in uncertain times.

Thinking Longer Term

While the dividend yield relationship between stocks and bonds is, at best, sending conflicting messages, that doesn't mean you can sit on the sidelines. If you need dividend income to pay bills, you need to own dividend stocks. The above companies have notable yields and reasons why they could hold up over the long term.

Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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