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Goodbye "T-Bill and Chill," Hello Dividend Stocks

The “higher for longer” interest rate environment is nearing its end. The Federal Reserve is widely expected this week to join other central banks, including the European Central Bank and the Bank of England, in cutting rates after generational high US inflation has receded back toward the Fed’s 2% target.

Coined by bond investor Jeffrey Gundlach in October 2023 as “T-bill and chill,” investors unsure how to navigate uncertain financial markets could earn over 5% by simply parking their savings in ultra-safe Treasury bills, money market funds and other cash equivalents.

 

Exhibit 1: Short-Term Interest Rates

 

 

A Market Rotation to Dividend Stocks

With interest rate markets pricing in multiple rate cuts, markets have rotated into higher-yielding sectors that had lagged year to date and whose yields look relatively more attractive now that yields are falling in anticipation of Fed rate cuts.

Quarter to date (through Sep 13), S&P 500® sector returns have been led by real estate (+17.7%) and utilities (+15.3%) stocks—two of the top-three yielding sectors (Exhibit 2). Energy stocks, which also boast high dividend yields, failed to participate however due to plummeting oil prices. Pricier technology stocks that had led the way in 2023 and the first half of 2024 have trailed, down -1.1%.

 

Exhibit 2: Higher-Yielding Sectors Are Outperforming QTD (S&P 500® Index)

 

 

Tax-Advantages of Qualified Dividends

For investments in taxable accounts, tax rates are an important consideration. Afterall, it’s not how much you earn, it’s what you keep. Dividends have an advantage here. Compared to interest income received from cash and corporate bonds, which is taxed as ordinary income, dividends are primarily taxed as capital gains. For example, a person in the top federal income tax bracket pays up to 37% on interest payments, but just 23.8% (20% + 3.8% surcharge) on qualified dividends. Yields on these different financial instruments can be evaluated on a tax-equivalent basis. Sticking with our example, the after-tax equivalent of a 5% cash yield is a dividend yield of just 4.13%.

With interest rate markets currently pricing in a greater than 50% probability of a target Federal Funds Rate of 3.75% to 4.00% by January 2025, one can easily see why dividend stocks are looking relatively more attractive. In the Russell 1000® Value Index, there are over 100 stocks that yield more than 4%.

 

High Yields on Income Funds, But What’s The Catch?

Exchange-traded funds that pay high rates of current income have been a hot category in recent years due to the “silver tsunami” of baby boomers retiring and seeking current income. Some of these funds, which have been called “boomer candy” even pay yields of more than 10%. Like anything that seems too good to be true, it probably is. A subset of these funds use covered call strategies—selling call options on stock holdings to generate derivative income. Investors like their high yields but may be surprised during tax season. This is because income from call premiums is nonqualified and thereby taxed as ordinary income at rates up to 37%.

Another subset of dividend funds with eye-popping yields are those that invest in companies with unsustainably high payouts due to weak underlying business fundamentals. Rather than grow their dividends over time as a function of their free cash flow growth, these companies use high dividend payouts to prop up their stock prices. While investors receive high income, they can actually lose money on a total return basis, if the stock price falls.

Whether it’s a surprise tax bill or a subpar total return outcome, we believe there are better approaches to seeking a balance of income and capital appreciation from dividend stocks. A portfolio of high-quality dividend stocks has the potential to provide an attractive yield, tax-advantaged income and participation in the upside potential of stocks, which can help preserve purchasing power over time. Dividend stocks can also offer diversification benefits that reduce overall portfolio volatility, helping investors stay the course when markets get choppy.