Our point at the time was that many of these dividend-focused ETFs had heightened embedded credit risk based on their BBB and below exposure, which is normally not an issue during a healthy credit environment and normal corporate borrowing levels.
The S&P 500 has roughly a third of its portfolio in BBB and below-rated issues, but the index concentrates its exposures to market capitalization rather than dividends. We argued that “since dividend-focused ETFs are delivering ‘participation’ in dividend-paying risk, they are more susceptible to a shift in capital allocation policies that prioritize debtholders over equity shareholders.”
Figure 5 displays the same list of ETFs with updated figures through July 31, 2019.
Figure 5: Credit Risk Exposures Of Dividend-Focused ETFs & The S&P 500 (updated 7/31/2019)
(For a larger view, click on the image above)
Comparing Figures 4 and 5, the projected dividend yields have not changed that much between last December versus this July, despite the strong market advance that has seen the projected dividend yield on the S&P 500 drop from 2.03% to 1.89%.
Dividend-focused ETFs with higher credit risk tend to have higher projected yields relative to their peers, as would be expected. Some of the higher yield may be due to discounting of zero growth or cuts in dividend payouts as lower-rated companies pay down their debt.
Pendulum Swinging Back To Dividends
However, given this year’s drop in interest rates and rally in corporate credit, dividend-focused funds with projected 3.50-4.50% dividend yields are starting to look more attractive from a total return standpoint. That’s especially true if we’re about to enter an earnings slowdown over the next phase of this 10-year-plus business cycle.
In other words, whereas the income-focused risk/reward favored credit over dividends last December, the pendulum may now have shifted in favor of dividends over credit. Investors in dividend-focused strategies may not see much of a growth in payouts over the near term.
However, the fallen angel downgrade risk is not as prominent today as it was late last year, as highly leveraged investment-grade corporations firm up their balance sheets to head off a ratings downgrade into junk territory.
Should the U.S. economy remain resilient while the Fed cuts rates as projected by Fed Funds futures, dividend-focused investing will be on firmer footing today versus late last year.
A balanced income diet of risk and reward may now include a portion of dividends. On the other hand, fixed income investors seeking yield in corporate credit should start to question whether they are being properly compensated at current spread levels.
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