Dividend investors have a new competitor, and it doesn’t need earnings growth, a turnaround plan or a CEO promising “disciplined capital allocation.”
It’s the Government of Canada.
The benchmark 10-year Government of Canada bond yield finished October 1 around 3.9%, while the long-term benchmark reached 4.3%. Suddenly, a dividend stock yielding 3% doesn’t look quite as impressive as it did when bonds paid far less. That doesn’t mean dividend stocks are finished. It means I’d check one number before buying them. That’s the yield spread.
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Spreading it out
The yield spread is simply the stock’s dividend yield minus the return available from a relatively low-risk government bond. Consider a stock yielding 5% when the 10-year Canada bond yields 3%. Investors receive roughly two percentage points of additional starting income for accepting equity risk.
If the stock yields 3% while the bond pays nearly 4%, the spread is negative. Now the company needs dividend growth, earnings growth, or capital appreciation to justify taking more risk.
This isn’t a rigid buy-or-sell rule. Government bonds and stocks do different jobs, and bond income doesn’t grow automatically. Yet the spread forces investors to ask a useful question: What am I getting paid for taking the extra risk? It’s especially useful when sorting through Canadian dividend stocks after bond yields jump. Hydro One (TSX: H) makes an interesting example.
A negative spread
Hydro One owns Ontario’s electricity transmission and distribution network, serving approximately 1.5 million customers. Nearly the entire business is rate-regulated, giving earnings more predictability than your average cyclical company.
At $51.05, Hydro One’s $1.41 annualized dividend yields roughly 2.8%. Against a 3.9% 10-year Government of Canada bond, that creates a yield spread of about negative 1.2 percentage points.
| INVESTMENT | CURRENT YIELD | SPREAD VS. 10-YEAR CANADA BOND |
|---|---|---|
| 10-year Government of Canada bond | 3.9% | — |
| Hydro One | 2.8% | -1.2% |
On income alone, the bond wins. Fortunately, income today isn’t the entire Hydro One story.
The payout keeps growing
Hydro One raised its quarterly dividend to $0.35 this year, another roughly 6% increase. The annual dividend rate has climbed from about $0.84 in 2016 to $1.41 today. That works out to dividend growth of roughly 5.3% annually over the decade. A government bond’s coupon won’t do that.
Hydro One also expects roughly 6% annual rate-base growth and has targeted 6%–8% annual earnings-per-share (EPS) growth through 2027. Second-quarter EPS rose to $0.62 from $0.54 a year earlier as approved rates and higher electricity demand lifted revenue.
Ontario’s growing electricity needs provide the current catalyst. Hydro One is advancing several transmission projects, including the Red Lake, Northeast, Longwood-to-Lakeshore and Durham-Kawartha lines. More infrastructure can expand the assets on which the utility earns regulated returns. That combination is why buying stocks in Canada can still make sense even when bonds offer more starting income.
Higher rates bite twice
There’s a catch. Utilities borrow enormous amounts of money to build infrastructure. Hydro One’s Q2 financing charges increased partly because long-term debt rose. The company also issued US$1 billion of five-year senior notes this year as it diversified its funding sources.
Higher bond yields therefore hurt utilities twice. They make competing fixed-income investments more attractive while making future borrowing more expensive.
Hydro One also trades around 21.6 times trailing earnings. Investors are paying a healthy valuation for predictable growth, even though its dividend currently trails government bonds.
Bottom line
When bond yields rise, don’t look at a dividend yield in isolation. Subtract the 10-year Government of Canada yield first.
Hydro One currently loses that contest by roughly 1.2 percentage points. Yet its growing dividend, rising earnings and expanding Ontario power network explain why investors may still accept the smaller starting payout.
The bond offers more income today. Hydro One has a chance to make the income considerably larger tomorrow.
