Reading: Why do Firms Pay Dividends?

Finally, it could also be that the market's demand for dividends changes over time. Especially in a market environment where yields on fixed-income securities are low, many investors view stocks that pay a solid dividend as a valuable alternative to corporate or government bonds.

For example, the yield on a 10-year U.S. Treasury Note has been below 3% for seven consecutive years since 2011 and the yield on a 10-year Swiss Government Bond has been negative (!) since 2015 and is around 0% at the time of this writing (June 2018). Similarly, the yield of a 10-year Japanese Government Bonds is around 0% and that of a German Government Bond is around 0.3%.

It is indeed difficult to make money with fixed income securities. In such an environment, investors could demand dividend-paying stocks as a substitute for bonds. Indeed, there are many companies that pay rather spectacular dividends:

• For example, AT&T has a strong history of dividend payments, with a 34-years dividend growth streak and a dividend yield of more than 6% in 2018.
• Similarly, stocks like Procter & Gamble, Coca Cola, General Electrics, Exxon Mobile, IBM, Pfizer, Verizon, etc. pay dividend yields that are often considerably larger than what government bonds pay.
• As we have seen in the introductory chapter, this phenomenon extends internationally, with many markets paying higher average dividend yields than the U.S.

It is fair to say that the low-interest environment has pushed many investors into high dividend stocks. And often, this movement has been backed by strong advertisement from financial advisors who offer investment vehicles that cater to this need.

It is important to understand that this substitution is potentially very dangerous: 

• A coupon payment on a bond represents a legal claim against the issuer.
• In contrast, there is no law that forces firms to pay dividends (at least on common stock), so that dividend payments usually are at the discretion of the board.
• Also the "principal amount" (i.e., the invested capital) is exposed to greater risks in the case of equity. The reason is that equity is a residual claim. Shareholders only get paid after the legal claims from the bondholders have been satisfied. Whereas bondholders are exposed to the credit risk of the company, shareholders bear the actual business risk, which is levered even further up if the firm engages in debt financing (See the module Cost of Capital for a very extensive discussion).

As a result, substituting fixed-income securities with dividend stocks might indeed increase the yield of the investment portfolio. Inevitably, however, this substitution will also expose the portfolio to different risks, in particular equity risks.