Buy the S&P 500 and Ditch Bonds for Higher Yields

These days, investors can earn higher yields in the stock market than they could earn owning Treasuries. Evercore ISI strategists argue that trend will continue for a while—even if bond yields rise.

The benchmark 10-year Treasury note was yielding around 1.8% in midday trading Thursday, while the S&P 500 index’s implied dividend yield is 1.9% for 2020. And that is before share buybacks, another popular way for companies to return cash to shareholders.

All in, about 80% of companies in the S&P 500 have total cash-return rates—dividends and buybacks—that are higher than the 10-year Treasury yield, according to Evercore.

“The absolute level of dividend payment has been stable and we expect high cash return to continue to support index valuations,” they write in a Jan. 16 note.

That seems like a pretty strong argument to own stocks instead of bonds. But what matters most is the future direction of both markets’ yields, and what that means for investment returns.

A stock’s dividend yield could theoretically soar if its price fell close to zero, for example, but that doesn’t mean investors would want to own it. And if a company gets into enough trouble, its management team usually cuts the dividend before risking a default or a credit downgrade to junk status—or even to cut a heavy debt load.

To assess that risk, Evercore surveyed comments from corporate management teams on their latest quarterly earnings calls. And they found that company executives were more optimistic about the outlook for dividend growth. That means dividends could grow more quickly in the future, the strategists say.

With all else equal, if the U.S. 10-year Treasury yielded 2.5% (instead of its current yield of 1.8%), about 70% of companies in the S&P 500 would still offer higher yields from cash return. That number would only improve if the increase in benchmark yields hurt stock prices without leading any companies to reduce their dividend payout, according to Evercore.

The problems arise when Treasury yields rise and corporate borrowing costs rise with them; most large-cap companies borrow at interest rates benchmarked to Treasuries. Evercore doesn’t address this scenario, possibly because companies tend to borrow at fixed rates, which means yields will need to stay high for a while to really affect corporate borrowing costs.

But if that happens, it is important to remember that interest payments to creditors take priority over dividend payments to shareholders. In that case, companies would be left with less cash flow to devote to dividends, which would mean slower dividend growth and potentially some dividend cuts.

That scenario seems far away now: The S&P 500 was up 0.57% to another new high in midday Thursday trading.

Write to Alexandra Scaggs at alexandra.scaggs@barrons.com