The current macro environment has strained the funding of capital-intensive companies that rely heavily on debt to generate stable cash flows. Energy, real estate, banks, and telecom companies depend on the return on investment after deducting the cost of capital to pay dividends. After distribution cuts by Slate Office REIT and utilities like Algonquin Power & Utilities, some investors are worried that high-yield dividend stocks aren’t safe.
When in doubt, go for the no-brainer stocks
The rising interest rate and business expenses due to inflation are straining the fundamentals of small- and medium-sized companies. But large companies are well-funded and have several income streams that keep cash flowing. Moreover, they get better credit terms because of their size and credit rating.
In the worst-case scenario, they might pause dividend growth but not cut them, as they keep their payout ratios below 70% of their distributable cash flow (DCF). The distributable cash flow is the cash left after deducting debt payments and capital expenditure. Generally, such large-cap stocks have a dividend yield of 3-4%. But three Dividend Aristocrats offer a 6% yield, making them a safer investment in tough times.
Enbridge (TSX:ENB) is a stock you can buy without thinking twice. This pipeline stock is at the heart of Canada-United States relations. Canada exports 99% of its oil to the United States through pipelines. Enbridge has the largest pipeline infrastructure in North America. It is transitioning from oil to natural gas and renewable energy as the industry transitions to greener alternatives. The company is investing heavily in gas pipelines to tap North America’s liquefied natural gas (LNG) exports. It expects LNG exports to grow by 200% by 2035.
Amid rising interest rates and high capital spending, Enbridge reduced its average annual dividend growth rate from 10% (in 28 years) to 3% in the last three years. Its dividend policy is to pay 60-70% of the previous year’s DCF. It aims to grow its operating profit by 5% every year. Enbridge grows its cash flows by adding new pipelines and the maintenance and life expansion of old ones. It passes the maintenance cost to customers through a higher toll rate.
Even if a recession triggers Enbridge can continue paying dividends, as its toll money is not affected by oil and gas prices.
BCE (TSX:BCE) is another large-cap stock that just completed an accelerated capital expenditure to roll out a 5G network. Unlike Enbridge, BCE faces competition from the other two telecom providers, as customers can choose their network provider. But it has been seeing a strong uptake in subscriptions. It has been paying regular dividends for more than 45 years and has grown in most years, with some growth pauses in a weak economy.
But times are changing. Broadband has become one of the biggest necessities. And this dependence will grow, as 5G connects more devices to the internet and make them perform mission-critical applications. BCE is unlikely to slow or pause its 5% dividend-growth rate thanks to a lower cost of capital and continued revenue growth.
Among the Big Six bank stocks, Bank of Nova Scotia (TSX:BNS) has the lowest exposure (6.86%) to the United States, as it diversified further south in Mexico, Chile, Peru, and Columbia. These are high-growth, high-return markets, where it provides personal and commercial banking services. Its customer loans are funded through wholesale funding instead of customer deposits. Wholesale funding has a higher interest rate because such countries carry higher risks.
The bank also operates wealth management and wholesale banking operations. The bearish market has reduced profits from wealth management, and a higher interest rate increased its interest expense for wholesale funding. Banks face significant credit risk, as higher interest rate seeps into mortgages and credit cards. You might feel the pinch of ballooning debt.
But being in the banking business for 190 years, Scotiabank has survived the Great Depression, the 1990s stagflation, and the 2007 recession. The 190-year-old bank has what it takes to maintain dividend growth. As the economy recovers, so will Scotiabank stock price.
The key to safe dividend investing is diversifying across sectors, and the above three stocks give you just that.