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Investment Strategy

Income Investing in a Low-Rate World

By Roger S. Conrad, on Jul. 27, 2016

Investors have plenty of reasons to expect the Federal Reserve to stand pat on interest rates this year: lackluster economic growth, the upcoming presidential election and deflationary pressure. As a result of this reprieve and concerns about the US economy, investors have piled into dividend-paying equities of all stripes.

Since mid-January 2016, iShares Select Dividend (NYSE: DVY)—an exchange-traded fund (ETF) that tracks an index of 96 US-listed stocks that pay dividends—has gained about 25 percent and yields about 3 percent. The ETF’s top 10 holdings, which account for roughly one-quarter of the fund’s portfolio, trade at an average of almost 20 times their trailing earnings.

As we’ve explained on numerous occasions in Capitalist Times Premium, the conventional wisdom that dividend-paying stocks’ fortunes tend to track interest rates doesn’t hold water over an extended time frame.

In fact, the Dow Jones Utilities Average generated a total return of about 48 percent when the Federal Reserve hiked interest rates by 425 basis points between June 2004 and June 2006. The Bloomberg North American REIT Index and the Alerian MLP Index likewise returned almost 40 percent over this period.

However, the conventional wisdom that rising interest rates are bad news can affect dividend-paying equities in the short term. The Federal Reserve’s decision to back down from hiking interest rates earlier this year, coupled with concerns about the US and global economies, has prompted investors to plow money into income-generating investments.

The 10-year Treasury bond has pulled back from the all-time high hit in early July but still sports a yield-to-maturity of 1.57 percent—a paltry annual return. And the Dow Jones Utilities Average hasn’t traded at more than 20 times earnings and yielded less than 3 percent since late 2000, when the S&P 500 was on the verge of a historic crash.

The Bloomberg North American REIT Index yields 4 percent and its enterprise value (equity plus debt) hovers at about 24 times trailing operating cash flow—near an all-time high.

For much of last year and the first month of 2016, investors had ample opportunity to buy our Lifelong Income Portfolio holdings at reasonable prices. Today, half our picks trade at prices that exceed our value-based buy targets. And many of the others are within a few percentage points of joining this group.

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