Traditional income strategies are supposed to be attractive to conservative investors. In particular, sectors with a high concentration of dividend-paying stocks (such as utilities and consumer staples) are often safe havens. These are referred to as "widow and orphan" investments because they are safe enough for the most risk-averse investors.
In today's investment environment, however, there's a problem. Not only are the yields on traditional dividend stocks depressed, but they also have much more embedded risk.
To understand why the strategy of buying solid dividend-paying stocks could be harmful to your account, we need to take a look at the state of financial policy in the U.S.
Reaching For Yield
It is common knowledge that we live in a period of exceptionally low interest rates. The Federal Reserve has intentionally driven interest rates to historically low levels in an attempt to boost economic activity. The Fed's expectation is that if interest rates remain very low, then income investors (both individuals and institutional investors) will move further out on the risk curve as they "reach for yield."
Reaching for yield can theoretically support an economic recovery. This is because capital naturally moves into more "productive" areas -- typically out of Treasuries and into corporate bonds, or out of bonds entirely and into equities. If companies are able to raise capital, which would typically be invested in safer areas, then it can help to boost expansion and support employment.
Considering the low interest rates over the past decade, a lot of capital has moved into traditionally safe income stocks that would have otherwise been in Treasuries or investment-grade bonds. This has pushed stock prices (and valuation metrics) to higher levels.
Capital Rotation in Reverse
Now that the U.S. economy is growing, the Fed is considering its options. And if it were to raise interest rates, then it would lead to lower Treasury prices and corresponding higher yields.
At this point, it looks like the capital rotation out of fixed-income securities and into traditional income stocks is near a peak. With the prospects for higher interest rates at some point down the road, investors need to be ready for the trend to shift. If this happens, we will see capital move out of dividend stocks and back into "safe" income investments with newly appreciated yields.
This reverse capital rotation could be very challenging for traditional dividend stock investors. Since these stocks are trading at premium valuations to historical norms, they could see significant capital outflows once their competitive income edge is lessened.
For this reason, we're worried that conservative dividend investors may be in danger of suffering significant losses in the months and years ahead.
A Better Alternative
One strategy that dividend investors may want to consider is selling put options. The benefits of this strategy are twofold: it can generate reliable income and also allow investors to potentially buy quality stocks at a significant discount.
Here's how the put selling strategy works... Income investors sell a put option, which obligates them to buy 100 shares of stock at the option's strike price if the stock is below that level when the option expires. Typically, we choose a put option that is "out of the money," which means the strike price is below the current stock price. That means our obligation only kicks in if the stock drops in price.
There are two ways the trade will evolve. Either the stock will remain above the strike price and the put seller will not be required to buy it, or the stock price will decline, in which case the put seller will buy the stock at a discount.
Income is generated from this strategy through the process of selling the put option. The income we receive, which is known as "premium," is basically compensation for accepting the obligation that comes with selling the put option.
We're not there yet, but if we find ourselves in a rising interest rate environment, then selling puts makes a lot of sense. They also make sense right now, because investors can generate higher yields in less time than with traditional income stocks. At the very least, this strategy offers an attractive diversification from traditional income stocks that may be especially vulnerable in the current market environment.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
