Banking on a sustained recovery, some investors are switching out of corporate bonds into dividend-paying stocks, but if a second recession ensues, those bets could turn bad. In a double-dip recession, which some analysts fear may happen next year, more companies may be forced to start cutting dividends, as happened in the recent economic crisis.
If that went hand in hand with steep falls in stock prices, corporate bonds might be a safer place to be than dividend stocks, especially if inflation were subdued, analysts said. "If you get a sell off, the stability of that dividend will be put in question," said William Larkin, portfolio manager with Cabot Money Management. "If we get a double dip, people will price in that those dividends are going to be cut."
In that scenario, high yield bonds would likely beat dividend stocks returns, provided the default rate for such bonds continues to fall, Larkin added. Such risks have not stopped bond investors plunging into stocks, on confidence in a sustained economic recovery, and fears of inflation - the bete noire of debt markets.
Stocks have surged on a tide of optimism the US economy grew again in the third quarter and will keep expanding. Bonds also appear less of a bargain after storming back from a panic selloff in late 2008. US investment grade corporate debt had total returns of about 18 percent year-to-date while high yield bonds have amassed more than 51 percent.
Yield spreads of some corporate bonds over comparatively risk-free Treasuries "are back to their historical averages," said Jamie Cox at Harris Financial Group. "Maybe the easy money has been made," said Cox, a managing partner at the Virginia financial planning and asset management company. "People are gravitating towards the equity market."
There, the dramatic erosion of dividends by companies in the S&P 500 stock index is past the worst, says Howard Silverblatt, senior index analyst at Standard & Poor's in New York. He estimates these companies' aggregate dividends will grow by a modest 3.5 percent in 2010, after plunging to a forecast $192 billion this year from $248 billion in 2008. But next year's forecast assumes the economy avoids another downturn and consumer spending holds up, Silverblatt said. With that proviso, growth-generated inflation could loom as the biggest threat to investors.
The prospect of inflation pushes up fixed income securities' yields and depresses their prices. At the same time, economic expansion could swell corporate earnings and continue boosting stocks. So some income-oriented investors are becoming tempted by the dividends stocks have to offer as an alternative to corporate bonds, fund managers say.
"If you are worried about rates rising and affecting bonds, the dividend is a way to get income," said Jeremy Schwartz, director of research with index developer and exchange traded fund (ETF) provider Wisdom Tree. Investors are more wary of dollar-denominated bonds. Flows since the summer have indicated growing concerns that an explosion of US government debt may punish the US dollar and stoke a big inflation problem.
The recent trend has been into emerging market funds while in currency funds "there is a big focus on the decline of the US dollar," Schwartz said. Since July, Wisdom Tree's ETFs in a basket of emerging market currencies, and funds in the Chinese yuan and Brazilian real have seen significant inflows, he said.
Enthusiasm for risky junk bonds has started to wane. Over the past two months, the weekly pace of US high yield bond fund inflows has dropped markedly, falling to about $340 million in the latest week from a $600 million weekly average inflow year-to-date, notes Brad Durham, managing director of EPFR Global in Boston. For others, it would be foolish to abandon bonds given doubts economic recovery will last.