New Investors: How to Get a Pay $$$ Raise Every Year
As the current stock market downturn shows, stock prices are unpredictable. Therefore, you can’t reliably predict that you can make money from stock price appreciation without speculating on what stock prices may do. Another way of making money from stocks is through dividend income. New investors can increase their odds of getting a pay raise every year by investing across a diversified portfolio of carefully chosen quality dividend stocks.
For example, just last week, I wrote that three dividend stocks, Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM), Canadian Tire (TSX:CTC.A), and Algonquin Power & Utilities, are good to consider this month. In the last week, their stock prices have move up and down, as shown below. They move seemingly to the tune of news or market sentiment in the short run. So, it’s quite pointless for new investors to look too closely into the short-term price movement. However, in the long run, you can expect them to move with the fundamentals of the underlying businesses. If the companies make more money on a per-share basis over time, you can expect their share prices to move higher over time.
In the graph above, Canadian Tire is the only stock that’s up in this period. It turns out that the solid dividend stock raised its dividend by 25% and, consequently, popped 6% on Thursday! This is surprising news, as the company announced the dividend increase, which is for September, ahead of time. Perhaps, in this market downturn, management is trying to demonstrate the company’s strength and stable financial position. The dividend increase surely did boost investor confidence, at least, in the short term.
So, how do you get a pay raise every year?
How new investors can get a pay raise every year
Businesses in the same industry are exposed to similar risks. When these risks play out, their earnings can be meaningfully impacted. Therefore, buying and holding a basket of diversified dividend-growth stocks increases your likelihood of getting a pay raise from dividends every year.
For instance, when the macro risks are heightened to a certain level for the Canadian economy, the regulator, the Office of the Superintendent of Financial Institutions (OSFI), would restrict the federally regulated financial institutions from increasing their dividends. So, around the time of the global financial crisis in 2007 and the COVID-19 pandemic in 2020, CIBC and its peers only maintained their dividends.
Looking at individual dividend stocks, new investors can go through the following checklist to increase their chances of getting dividend increases. First, the dividend stock should have a track record of maintaining or increasing its dividend. Of course, increasing dividends healthily is always preferred, but any stock that’s able to even maintain its dividend safely is praise-worthy.
Second, the more stable the stock’s earnings or cash flow is, the better. For example, utility stocks like Algonquin have pretty stable earnings to protect their dividends. Typically, the more the unpredictability of profits, the lower the payout ratio should be. This is why cyclical companies like dividend-paying industrial stocks typically have low payout ratios.
If you’re not sure what is considered a healthy payout ratio of a company, observe the payout ratios of its peers. It should align with the industry payout ratio.
Dividend investing is only another way to earn a living. 2 Canadian Dividend Stars for TFSA Passive Income.
For several months now, inflation has been hitting levels not seen in decades. In March 2022, inflation hit 8.5%, the highest since 1981, and then moderated only slightly to 8.3% in April.
In such an environment, while it may look neutral or even beneficial to hold cash, cash is declining in value. The pile of dollars you have may look constant, but inflation is a thief in the night stealing the purchasing power of your cash. Inflation is a hidden tax on everyone.
Housing prices have been increasing rapidly since last year, and rental prices are surging. Rents were up 11.2% in 2021. With rent increases tending to be “sticky,” these rents are not going away soon.
Energy prices are up as well. Looking at the prices on OilPrice.Com we can see the big runup in prices over the last year. While prices are down a bit from the peak (caused by Russia invading Ukraine), the trend has been upwards. The costs of energy impact the prices of everything.
Oil price over the last year
Oil Price over the last year (oilprice.Com)
Investing in dividend stocks in industries with pricing power is our preferred way to reduce inflation risk. However, any investment in the stock market comes with risk. I am often asked about good places to “park” cash to protect it from inflation.
With the Treasury markets in turmoil, putting downward pricing pressure even on very “safe” bonds, historically good parking spots risk a price decline. While much “safer” than equities, these funds are not risk-free, and the dividends are currently low (though rising).
iShares Short Maturity Bond ETF return data by YCharts
Fixed income across the board has sold off. Treasuries, agency MBS, and short-term bond funds have all declined. These investments do an excellent job insulating you from credit risk, but they don’t protect you from inflation risk.
Usually, someone looking to “park money” isn’t concerned about getting a high return but is more concerned about making sure the money is not at risk. They want the buying power of the money to be more or less the same in the future as it is today.
Where can we park our money, take zero pricing risk and protect it from inflation? The U.S. Federal government offers an investment that does all three.
I-Bonds Make A Great Inflation Hedge
Series I Savings Bonds are bought directly from the U.S. Treasury. Similar to regular savings bonds, they are designed to help ordinary people save money. They pay interest that combines a fixed rate and an inflation rate. Additional details are available at this link to Treasury Direct.
Electronic I-bonds are available in any amount, to the penny, from $25 to $10,000. You are limited to buying $10,000 in any one year, with an additional $5,000 that can come from your tax refund. This limit is per person so that a married couple could double these amounts.
The bonds are meant to be held for the intermediate to long term. So avoid them if you want access to the money in a few months. The bonds must be held for a minimum of 12 months. In addition, if you redeem a bond before five years, you lose the last three months of interest payments. This discourages shorter holding periods.
How The Interest Works
Currently, I-Bonds are offering a higher yield today than in the past: 9.62% for bonds purchased in May through October 2022. This consists of a 0% fixed rate and a 9.62% annualized variable rate. The variable rate resets every six months from the month the bond is issued. At the end of 6 months, the rate will be reset higher or lower based on inflation.
The interest is accrued and then added to the principal every six months. So you will not receive cash payments. Instead, the interest owed to you will be added to the principal at the end of 6 months. So at 9.62%, if you buy $10,000, you will receive approximately $481 in interest at 6 months when the rate is reset. Then the next 6 months, you will earn the new rate of $10,481. This will continue every 6 months until it matures in 30 years or you decide to redeem them.
How To Buy I-Bonds
There are two ways you can purchase I-Bonds.
You can also purchase I-Bonds electronically from the Treasury Direct website. You can also set up a payroll purchase program. The directions are here. The electronic version of I-Bonds is available in any amount (up to the penny) in values from $25 to $10,000. You can purchase up to $10,000 a year of electronic I-Bonds. This limitation will force those who want a very large allocation to I-Bonds to purchase regularly over several years.
You can purchase them in paper form using your income tax refund when you file your tax return. Instructions can be found here. You can purchase a maximum of $5,000 of paper I-Bonds each year (using any tax refund you get). This does not include any paper I-Bonds you have purchased during the year. Paper I-Bonds are less flexible than the electronic ones and are only available with face values of $50, $100, $200, $500, and $1000.
I-bonds carry no principal risk. After 12 months, you are free to redeem at any time, and you will receive your face value plus accrued interest. You can request redemption through Treasury Direct, or if you have paper I-bonds, you can redeem them at any bank. Since these are backed by the U.S. Government, there is no worry about defaults. With no market trading them, there is no variation in prices. You know exactly what you will get and you can check the precise amount at any time through Treasury Direct.
If you are redeeming within 5 years, there is a penalty of the most recent 3-months interest. After 5 years, there is no penalty at all.
Comparing I-Bonds to TIPS
In addition to I-Bonds as an inflation-protected bond investment, the U.S. Government also has TIPS (Treasury Inflation-Protected Securities). Count on the Government to never have one program when they can have two or more!
The Treasury does provide a webpage explaining the difference between TIPS and I-Bonds.
While you can only buy I-Bonds from the government, there are several ways to buy TIPS, including banks and brokers. Here is a link describing how to buy TIPS. This also allows for the inclusion of TIPS into various funds, like the ETFs iShares TIPS Bond ETF (TIP) and iShares 0-5 Year TIPS Bond ETF (STIP). I-Bonds can’t be included in funds, so you have to own individual bonds. While it may seem like a benefit to be able to buy TIPS on the open market, this means that, unlike I-Bonds, the price you pay is determined by the market and is often not the same as the face value.
With TIPS, the interest rate is set at auction, and the inflation protection adjusts the principal amount. The adjusted principal amount is then used to calculate the semi-annual interest payment. With I-Bonds, the base rate is set when you purchase them, and the variable-rate portion of the interest is calculated every six months. Interest then accrues until the bonds are redeemed.
With TIPS, the face value changes with inflation (and can go down if we have deflation), but you are guaranteed to get the original face value at a minimum on redemption. With I-Bonds, the face value never changes and is guaranteed.
With TIPS, you get semi-annual interest rate payments, so unlike with I-Bonds, you don’t have to redeem the bond to get your interest payments.
When the market is underestimating inflation, the market-tradable TIPS will be priced lower than what their actual performance will produce. Suppose the market is already projecting high inflation (like now). In that case, TIPS can become expensive, and you risk overpaying if the market is projecting inflation will be higher than it ends up being. Whether or not TIPS are a good buy depends on whether or not the market is over or underestimating future inflation.
I-Bonds Pros Vs. Cons
Let’s take a look at the pros and cons of I-Bonds:
The principal is super safe and guaranteed by the U.S. Government.
I-Bonds pay variable interest based on CPI-U, a broad inflation metric.
Today, inflation is high, and I-Bonds bought in May will receive the current 9.62%+ rate for 6 months.
No matter how high inflation goes, you can rest easy knowing the bond’s rate will keep up.
You can redeem I-Bonds whenever you want after 12 months. Redemption is relatively quick, from immediate cash in a bank to a couple of days if redeemed electronically.
The penalty for redeeming I-Bonds before 5 years is lower than for CDs (and the rates are better too).
The fixed-rate portion is 0%, so your return will match inflation but will not exceed it unless inflation drops significantly before the next reset.
Returns will come solely through interest payments since the bonds can only be redeemed through the government at face value. No chance of capital gains.
To avoid the 3-month penalty, you must hold for 5 years. If you sell within 5 years, your total return could be slightly lower than inflation.
Interest accrues, and you won’t receive any cash until you redeem them. The good news is that interest is compounded.
With the yield on I-Bonds at more than 9%, they are very attractive as a mid to long-term parking spot. Note that if inflation slows down in the next 6 months, the future yield will be reduced. So unless inflation keeps accelerating, your actual yield will be lower. These are designed just to keep pace with inflation, not to profit from it.
You can even set up a payroll deduction purchase of I-Bonds for convenience. Investors are limited to just $15,000 in purchases a year. For most, that is a healthy little cash reserve, and you can choose to add more next year. It provides the same benefit of ultra-safe principal you get with U.S. Treasuries while providing inflation protection.
After the first year, I-Bonds can make a great emergency reserve since they can be quickly cashed in any economic conditions. This allows you to hold a near-cash position that is significantly hedged against inflation.
I-Bonds are a great option to hold cash that you don’t need for at least a year and want to protect that cash from inflation. We expect that inflation will remain elevated over the next few years. I-Bonds are currently a very safe inflation hedge.
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