Avoid the highest-yield stocks

The returns from the last 30 years aren’t good predictors of the future.

Instead, “use current low bond yields — which are much better indicators of what to expect going forward — to plan,” says Jim Gilliland, CFA, head of fixed income at Leith Wheeler Investment Counsel in Vancouver.

Incorporating stocks in addition to the near-term income that a bond portfolio offers is “a much better alternative than completely escaping the market, for those uncomfortable with volatility.”

Short-term interest rates will likely remain low for the next several years, and investors must revise their expectations for bonds downward, Gilliland told attendees at Leith Wheeler’s 2013 market outlook event held in Calgary Thursday.

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But there’s also risk in turning to high-yield instruments, such as monthly income funds or high-risk preferred shares, Gilliland cautions.

“You are not necessarily well-compensated for that risk … beware of advertised yield. Headline yield [won’t necessarily] be your realized return — any type of downgrade or default will lower that return.

“You want to consider sustainability. Consider a diversified fixed-income portfolio and a set of reasonably priced stocks, based on individual risk tolerance.”

Read: Why to buy dividend stocks now

At a time when most fixed-income investments are not offering value, dividend-paying stocks — and stocks in general — are reasonably valued, Gilliland adds.

“Having that equity component is a key way to boost returns. A balance of higher-quality corporate bonds and good dividend-paying equities combined will do better than chasing the highest headline yield.”

Read: Dividend-paying stocks making a comeback

Patrick Reddy, CFA, a Leith Wheeler Canadian equity analyst, told the audience dividend initiations are reaching 18-year highs, “because balance sheets are a lot healthier today than they were in the past, and companies have a lot more financial flexibility.”

But the highest-yielding stocks might not be the best performers: they could be under-investing in their businesses, or distributing all earnings as dividends.

Companies that offer premiums, instead, hit the sweet spot. And the growth and sustainability of a company’s dividend is much more important than its absolute level.

Read: Don’t underestimate the power of dividends

This is borne out in the data.

From 1986 to 2012, companies that were consistent dividend growers performed much better than companies that were dividend payers on average, outperforming the TSX composite index by 5.5 percentage points in an equal weighted portfolio of companies.

Over the same time period, the worst performers were dividend cutters, which offered unsustainably high dividends, and underperformed the overall market by more than four percentage points.