Debt: Still The Top Threat to Your Dividends

And many investors are in for unpleasant surprises this year.

Since the beginning of 2022, the Federal Reserve has raised the Fed Funds rate from basically zero to 5.5 percent. Their actions have pushed up money market yields from near zero to north of 5 percent.

Longer-term interest rates have risen as well. The yield on the 10-year Treasury note, a benchmark rate for other bonds, has been in the neighborhood of 4.5 percent all year. That’s nearly triple where it started 2022.

Higher interest rates mean higher borrowing costs for individuals and businesses, as well as governments. Rates on 30-year fixed rate mortgages are approaching 8 percent. Some home equity lines of credit are now charging more than 9 percent. And even investment grade corporations pay twice as much to issue bonds as just two years ago, forcing them to cut spending as a result.

Last week’s inflation numbers showed once again the Fed’s attempt to “go Volcker” isn’t having nearly the impact advertised. In fact, housing costs are now the primary driver of Consumer Price Index increases, proof positive central bank policy is actually increasing inflation.

Let me explain. It’s undeniable that higher mortgage rates have greatly increased the cost of buying a home the past two years, which has forced many Americans to rent instead. And at the same time, higher borrowing costs have discouraged developers from building new apartments. The result is higher rents. And it’s now showing up clearly in financial reports of major landlords like REITs.

Take the Q1 2024 results of two of the largest residential property REITs, AvalonBay Communities (NYSE: AVB) and Mid-America Apartment Communities (NYSE: MAA). Avalon focuses mainly on urban centers while Mid-America owns in the Sunbelt. But both companies highlighted stronger than expected rent growth in early 2024. And as a result, they were able to boost their full-year profit guidance meaningfully. That’s good news for their investors, but bad news for renters and inflation.

Amazingly, the Fed still doesn’t seem to get it. Slightly lower April inflation sent the stock market soaring last Wednesday. But several central bank governors went out of their way to say in response “more progress is needed” before interest rates can be cut. And at least one specifically cited housing costs as a reason to keep interest rates high.

That kind of thinking is only believable when you realize this Federal Reserve isn’t loaded with luminaries or seasoned market pros as in the past. Rather, it’s stacked with market watchers trained to seek consensus.

We can never rule out dramatic shifts in policy depending on the “group think’s” reactions to the data du jour. But it does seem likely that we need to be prepared for borrowing costs to remain at current levels—and even go higher if “the data” are volatile enough. And that means being acutely aware of how any company you could be affected, based on the level of debt it carries as well as future needs for more borrowing.

Don’t think you can dodge this problem by owning ETFs and funds instead of individual stocks. That’s a mistake many owners of mutual funds have made all too often in the past, both in open-end and closed-end funds traded on major exchanges.

Fund managers are under no obligation whatsoever to keep paying whatever dividend they are now. And as an independent director of a group the last decade, I can assure you distributions investors are counting on are funded by multiple sources besides just the dividends and interest paid by the stocks they own.

Exchange traded funds or “ETFs” are even less reliable when it comes to dividends. The $522 billion SPDR S&P 500 ETF Trust (SPY) now pays just 1.2 percent. And investors can’t even count on that: The April 30 dividend was actually -16.3 percent less than what SPY paid in January.

The most popular dividend stock ETF is iShares Select Dividend ETF (DVY) at about $19 billion in assets. It’s also often used as a benchmark for performance of various income strategies. The ETF, however, yields less than 3.2 percent. And the March payment was -16.1 percent less than the December 2023 distribution—as well as -31.9 percent below the October 2023 payment.

That’s an unacceptable haircut for someone depending on dividend income. And it’s a pretty stark indictment of ETFs as the investment vehicle of choice, as pushed by giant Wall Street firms that are always pushing to suck up more investor dollars.

Of course, there’s an easy way around this pitfall for income investors. That’s to pick your own stocks and bonds, as any number of brokerages will now allow you to do at the lowest costs in history.

Taking control of your investments is exactly what I recommend everyone reading this do right now, if you haven’t already. But I do have one very, very important caveat: Before you buy anything—stock or bond—make sure you understand the company that’s ultimately making the payments. And in the current environment of higher for longer interest rates, there’s no greater threat to dividends than an unsustainable debt burden.

I use five basic criteria for choosing what companies I want to own, and which I will avoid like the plague. I’ll share them with you here:

·      Dividend policy sustainability

·      Revenue reliability

·      Regulatory relations

·      Refinancing and balance sheet risk

·      Operating efficiency

Together, they’re the basic screen I run for each of the hundreds of dividend paying companies in the coverage universe for my advisories. The specific metrics I use vary from industry to industry.

For example, a technology company with a hefty amount of debt is at far greater risk than a utility company with the same percentage. That’s because the utility’s revenue is recession and competition proof, while the tech company’s depends on short-life product cycles.

Running my screens has saved my readers and I the pain of countless dividend cuts over the last four decades. One example this month: Debt heavy broadband fiber company Uniti Group (NSDQ: UNIT), a former Wall Street favorite that will eliminate its dividend when it merges with rapidly shrinking telecom Windstream Holdings. Shares are down about -40 percent since.