Dividend Cuts and Interest Rates

Recently I wrote about how Interactive Brokers was offering to lend money at 1.25% in order to purchase stocks yielding 5% or more in dividends. I was struck by the low rate that they were able to offer as interest and the fact that there was a large universe of large companies offering such high dividend payouts (and not just companies that had a stock price decline with a dividend cut yet to follow so it was unusually high relative to the stock value).

To give Interactive Brokers some credit, the ad was kind of “tongue in cheek” in that it was made to look like it was written on a napkin like the classic business plan but there were enough elements there to get me thinking about what an odd state of affairs this represented.

Just recently this model started coming under siege. The Fed recently began tightening interest rates, increasing the discount rate to 0.75% from 0.5%. While the Fed has been denying that this is part of a long term policy shift, the markets have started to feel otherwise, as markets went down and yields increased on government debt. This won’t directly impact the 1.25% that they are able to borrow for on the “napkin” today, but it seems to be trending that way, even if this is just a first step.

On the other side, 2 large European firms just cut their high dividends. Daimler Benz (DAI), manufacturer of Mercedes autos, suffered a loss and canceled their dividend, leading to a drop of 4.6% in their stock price in one day. Societe Generale, a large French investment bank, cut their dividend from $1.2 Euros to $0.25 Euros (a drop of 79%) and their stock also fell 7.2% in a day.

The question is – how can companies pay out such high dividends in a sustainable manner when there isn’t much growth in the world economy and many of them are in mature industries? While 2 stocks don’t constitute a balanced statistical survey, they show that dividends are a function of profits and long-term profit view and to talk about them in an “historical” view is backwards.

The other side of this is that investing for yield in such a volatile area as stock prices shows that not only did the long term value of the income stream from dividends drop significantly (in the case of Daimler it dropped to zero, and for Societe it dropped by 79%) but then you can also see the impact on the underlying value of the shares, which dropped 4.6% and 7.9% in ONE DAY.

Cross posted at LITGM and Trust Funds for Kids

Leverage, dividends and our insanely low interest rates

Like the famous Seinfeld episode where Kramer struggles to figure out how to profit from the fact that Michigan offers a 10 cent return on recycled bottles, I have been starting at this ad from Interactive Brokers for some time now. This had has been run in myriad financial papers and I have seen it all over the place. It is notable for the fact that it looks like it was drawn “on the back of a napkin” like the fabled dot-com business plans.

The specific elements of the investing plan are as follows:
– Interactive brokers can make margin loans at 1.25% annual interest. This LOW rate of interest is made possible by the country’s current super-low rate policy
– Some stocks are offering dividends as high as 5%. In the current low interest rate environment (you are likely to get 2% on CD’s & government paper, and almost nothing on your money market and bank deposits), that 5% rate seems very enticing, especially since dividends are taxed more favorably on individuals than interest income (dividends are as low as a 15% rate, while interest income is as high as 35%+)
– Interactive brokers will offer you LEVERAGE. By leverage, this means that they will LOAN you more money than you have in your brokerage account so that you can invest and magnify your returns, either UP or DOWN

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We Are Wrong on Rate of Return

In this article titled “Why Many Investors Keep Fooling Themselves” by Jason Zweig from the Wall Street Journal, Mr. Zweig does an excellent job of explaining why individuals assume that they will receive a rate of return that is too high, which means that either they are not saving enough to meet their goals or that they are taking too much risk of running out of money.

This post describes what the rate of return means in practical terms, and why it is important.

One of the core elements of investing is the assumed “rate of return”. Along with your base investment (or amount that you are periodically adding, say annually), your time frame (number of years out you want to go), the “rate of return” is the percentage variable used to determine whether you will have enough to retire and / or meet your needs for a specific goal (such as will you have enough funded to send your child to college).

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Buying CDs Through A Brokerage

Recently I covered iBonds, which are a government bond that you can purchase online that provides assurance against increases in inflation and other tax benefits. The amount you can purchase is limited, however, to $5000 / year, and you can’t redeem them for 12 months, which makes them unsuitable as a short-term cash vehicle.

Certificates of Deposit (CDs) Through a Brokerage:

If you are looking for a practical way to earn interest income with the minimum risk possible than certificates of deposit are a good alternative. When I was growing up you had to physically go to a bank and set up a CD, and then you had to retain paperwork for each instrument. In addition, you wanted to disburse your funds among a number of banks to get around FDIC limits, as well. Finally, the CDs were not easily redeemed, although you could redeem them in some circumstances depending on the issue with a penalty on interest.

Today – all of above disadvantages and inconveniences with certificates of deposits have been eliminated. You can buy CDs online (I used to go through a voice broker, but last time the guy showed me how to do it myself, online, so now I will just purchase them that way), they are integrated with your brokerage statement so there is no additional paperwork (on issuance, or at year end for taxes) beyond what you already receive, and also there is a “secondary” market when you can re-sell your CD if you need the proceeds sooner. There is no “guarantee” that you will be able to sell your CD at the price you want, but since a CD is a simple commodity with a rate, timing payment frequency, and a duration, I’d expect that you’d be able to sell it for something very close to the market price and receive not only your cash back but essentially be made whole on your interest. However, the overall interest rate market may have changed which would mean that your CD would be worth “more” or “less” if you had to sell it – longer dated CDs that I purchased a couple of years ago are now selling for more than 100 cents on the dollar (say 102) but that would only come into play if I decided to sell them prior to their redemption date, which I don’t plan to do.

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