The case for dividends

Dividends are a payout of a company's profit and cash flow to its investors. When you invest in a successful business, the dividends it pays can become a reasonably reliable income source for years, even decades.

Preferred tax treatment. What catches most people's attention around dividends are the tax benefits. Dividend investments offer a tax advantage over other investments such as bonds* and term deposits. When held outside of a registered plan, eligible dividends – generally those from Canadian public companies – can benefit from the Dividend Tax Credit. With the credit, dividend income attracts far less tax than interest income does.

Let's say you earn $1,000 in investment income this year. If you're in BC's top tax bracket, you'll pay $437 in tax if you received that $1,000 as interest. But if you earn it in dividends, you'll only owe $261 – that's 40% less (based on 2012 marginal tax rates on dividends and interest for BC residents found at www.taxtips.ca). Spread that tax reduction over even a part of your investment portfolio and the savings can mount.

More (and more) income. Bonds may offer a predictable return, but that return is also guaranteed not to grow over the life of the investment. Dividends, on the other hand, have the potential to rise, and in some cases, quite dramatically.

Take the case of CN Rail. Imagine you received $1,000 in dividend income from the railway in 2002 and the same amount as interest income that year from a 10-year Government of Canada bond.

With the dramatic fall we've seen in interest rates over the past decade, an investment in the same bond today would only pay you $380 annually. The CN stock? With the steady annual dividend increases the company has delivered, your $1,000 would have grown to nearly $5,300 as annual dividend income this year, an 18% compounded annual increase in income. Even ignoring the tax upside, in this case your income growth is well ahead of inflation and outpaces the income from bonds.

Higher, more stable returns over time. While the CN example highlights what's possible through dividend-paying investments, studies have shown that share prices of companies that make, and better yet increase, their dividend payments have outperformed the broader market indexes with less volatility and trumped dividend non-payers.

Dividends have contributed significantly to the stock market's total returns over the years. Since 1988 a full 44% of the growth in the S&P/TSX Composite Index can be attributed to dividends.

So ignoring dividend stocks in favour of the market's high-fliers or the latest hot sector can significantly cut into your portfolio's performance over the longer term.

Why dividends now?

A generation ago, regular, predictable dividends from stable companies were highly prized. Then along came the roaring bull market of the 1980s and 1990s. The stock market's double-digit returns during those years made most dividends pale in comparison.

Fast forward to today (2012). Market volatility, low interest rates and other factors have put dividends back in focus. While the broader markets in North America were flat to down in 2011, sectors laden with dividend-paying companies like utilities, telecommunications and health care racked up gains as investors enthusiastically bought in.

So is it too late to invest now? There are several reasons why adding dividend-paying investments to your portfolio still makes sense.

First, compared to fixed-income alternatives, the dividend-paying investment market is attractive. In fact we're experiencing a rare event.

The S&P 500's dividend yield is higher than the yield on the US 10-year Treasury bond for only the second time since 1958. In Canada, the S&P/TSX Composite's yield is now approaching 3%, far above government bond and term deposit rates. Investor thirst for safety has driven interest rates so low that many fixed-income investments are now experiencing negative real rates of return (i.e. yielding less than inflation).

Conversely, the common shares of many blue-chip Canadian companies – BCE, Royal Bank and TransCanada to name a few – are yielding 4% or more. Add the preferential tax treatment and that's a compelling return in today's income markets. What's more, corporate balance sheets and earnings have been strong, leaving corporations greater room to increase dividends moving forward.

Want to hedge your bets against stock market uncertainty? If economic growth remains muted and equities tread water, dividend income is likely to contribute a lot to your overall returns. With dividends you're "paid to wait" for better times. And when markets do break out, owning dividend-paying stocks means you can still enjoy the ride.

Finding dividend income

If you want dividends, they aren’t hard to find. Investing directly in the equity of dividend-paying companies is one way. Common shares and preferred shares are some potential sources of dividend income. If you go the direct route, it's important to invest enough capital to be properly diversified.

For many investors a better choice might be mutual funds* or exchange-traded funds* which offer diversification and professional management for a smaller investment. There are plenty of options. Choose products with exposure to the broad equity* market or vehicles holding only dividend payers, growers, or preferred shares for example.

Each approach offers advantages and disadvantages around management, trading costs and convenience, so ask your advisor to help you review the trade-offs.

Whichever tack you take, "averaging in" to the market with a series of smaller, regular investments can be a smart way to reduce risk. With the strong run dividend-paying stocks have had, this strategy will lessen the odds that you'll load up at the top of the market. Better still, you'll potentially reduce your average investment cost over time, enhancing your returns.

Working dividend-paying investments into your portfolio

How far should you go to work dividend-paying investments into your portfolio? The answer will depend not only on your income needs and growth objectives, but on your risk tolerance as well.

While they add value in today's market, dividend-paying investments aren't guaranteed and can be more volatile than fixed income choices. For these reasons dividend paying investments can supplement, but probably shouldn't replace, your core fixed rate investments.

Make sure you’re diversified

Concentrating on dividend payers can overload your portfolio with the "slow and steady" like utilities and phone companies. The problem? It can leave you underweight in more cyclical sectors like energy and materials, which tend to outperform when economic activity picks up. Review your equity portfolio in its entirety, making sure you have enough diversification to meet your risk tolerance and goals.

Having a good variety of dividend-paying securities will help protect you from a particular company or sector hitting hard times. But creating a healthy roster of strong dividend payers across a wide range of sectors isn't easy to do if you limit your search to companies here at home.

It's true you’ll find lots of dividend-paying candidates among the banks or pipelines. But finding the same in health care, industrials or consumer staples? That won't be as easy unless you look abroad.

Consider adding at least a few U.S. and foreign dividend-paying stocks to your holdings. They'll provide added diversification across industries and help hedge your portfolio and investment income against declines in the Canadian dollar.

The joy of reinvesting

If you don't need much income or have a long investment time horizon look for options that let you reinvest your dividends. Why? Research from Morningstar, a leading investment fund research firm, showed that for the decade ending in 2010, average annual returns from the S&P/TSX Composite turned out to be 57% higher when dividend payments were reinvested. The bottom line is the compounding effect from reinvesting dividends can make a huge difference to how much you'll have in the end.

Structure for tax savings

You shouldn't let tax concerns be the only driver for your investment decisions, but how well you organize your dividend paying assets for tax-efficiency can boost, or hold back, your returns over time.

As mentioned above, a major tax benefit of investing in Canadian companies is the Dividend Tax Credit. However, you can only capitalize on this incentive if your dividend payers are held in a non-registered account and not in a TFSA, RRSP or RRIF.

Foreign dividends are another matter. They're taxed at full marginal rates. Also look out for withholding taxes levied by the company's home government. Canadian investors can, in many cases, offset the withheld income tax by claiming the foreign tax credit if those foreign companies are held outside of a registered plan.

Note that because of the U.S.-Canada tax treaty, dividend income from American companies isn't subject to those same withholding taxes if held in an RRSP or RRIF.

Structuring your dividend income for tax-efficiency especially when foreign income is involved can get complicated. Get professional guidance to make the proper decisions.

In the short run, it's difficult if not impossible to know which investments will do best. Fads and over-hyped concepts can top everything else for a while (remember the dot.com era?). Dividend-paying investments might not be a sure-fire path to riches, but over the years it's been a proven strategy for delivering growth and income to investors.

It doesn't matter if you're looking to beat low interest rates and produce more investment income, or grow your nest egg for the future. Dividend-paying investments can make a difference. Contact your BlueShore Financial advisor to learn more.