This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, March 31, 2010

Defending Dividends

The past several weeks, there has been a conflict brewing in the world’s bond markets. Though known by few in the public, currently many bond traders are waging a buyers’ strike – refusing to buy bonds – until equity markets undergo a correction.

These problems in the world’s bond markets are not limited to the private sector. At present this buyers’ strike extends to US government bond auctions, which have been making headlines as they fail to find adequate buyers to finance a growing debt.

In fact, if nothing else tells us of the market’s coming correction, it is that at this point even the government needs the stock market to correct so that bond traders will lift their buying strike. Unfortunately for investors in the stock market, the US government more often than not gets what it wants.

Given these deficiencies in debt markets, investors, particularly those with a focus on income, would be wise to consider alternative strategies. One such strategy for achieving this income is to seek out and purchase stakes in companies that pay relatively high dividends.

This strategy, like debt securities, provides a regular stream of income from a company to its investors. And yes, as many investors will undoubtedly point out, this strategy does put investment principle at risk. However, few realize that they risk principle in bonds as well, in several ways.

First and most obviously there is the risk of default by debt issuers. If the debt burden of a corporation or a government becomes too great, there are ways for these entities to relieve themselves of their debts owed to creditors, similar to bankruptcy protection for individuals.

This threat of default, which has been spoken of repeatedly regarding every issuer of debt from homeowners to governments, is very real in today’s environment. Between government debt, corporate debt, collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), mortgage-backed securities (MBSs), etc, the world of debt investments is an immense minefield that requires a great deal of care for investors to navigate.

Second, and less widely recognized, there is a risk of principle in bonds for any investor who intends to sell their bonds before they mature, which can be decades into the future. If an investor tries to sell bonds into the market, and interest rates have risen since they purchased those bonds, the investor will take a hit on their principle in order to find a buyer of their bonds who is willing to accept less than current interest rates.

Another aspect to consider when debating debt-derived income versus dividend-paying stocks is the psychology behind how investors are being paid. For example, investors who are collecting dividends from stocks are being paid by companies that produce a product and produce sufficient revenue to make regular dividend payments to investors, after operating expenses are paid (and debt is serviced).

On the other hand, quite often bond investments are made in companies, and governments for that matter, that have leveraged their balance sheets (borrowed money) to expand, or even just to keep their head above water. For whatever reason, many of these companies do not have the revenue to pay regular dividends, which is why they are issuing debt in the first place.

Certainly stocks are not always the best option for an investor, even if they are focused on income. However, given the difficulties facing our financial markets today, it’s very wise to consider every opportunity. And with the amount of credit being unwound by individuals, corporations, and governments (e.g. Greece) in any way possible, bondholders face default risk to a degree not seen in many years.

With our country’s rising deficit and burgeoning national debt, there is no guarantee that our government will not one day look for ways to relieve itself of its growing debt burden, even if it means leaving its creditors twisting in the wind. Given all these threats facing the debt markets, can investors really rule out income-producing stocks as an option altogether, or aren’t they at least worth a look?

Disclosure: The author, Dock David Treece, and his firm, Treece Investments, currently have holdings in high-dividend-paying stocks, and have advised clients to do the same.

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