Ep. 148: Fed Day and the Great Dividend Rotation

Right now, I mean, as we said here today, the 10-year treasury is yielding a, well, just a staggering 5%.
Yeah, it's a huge number.
It really is. And we are staring down the barrel of a federal reserve rate hike this afternoon.
Right, which is the first one since 2023.
Exactly. It's totally reversing their recent cycle of rate cuts. Now, you would think with that kind
of uncertainty in the financial world, investors would be, I don't know, hiding under their desks.
You'd definitely assume total paralysis, yeah.
Right. But looking through the sources for today's deep dive, it's actually the exact opposite.
We are tracking this frantic record-shattering migration of cash.
Yeah, that expectation of higher rates has triggered what we can only really describe as
a massive wall of money. It is physically moving through the markets in real time.
A $446 billion wall of money to be exact.
It's just massive.
It is. That's how much has flooded into bond ETFs just year to date.
I mean, they shattered the previous full-year record of $439 billion.
And we still have months left on the calendar.
Plenty of time left, yeah.
So, our mission today is basically to follow that money.
We're witnessing what's being called a great dividend rotation.
Which is fascinating to watch.
Right. With interest rates high and equity prices softening up a bit,
we are going to trace exactly where income investors are putting this cash to work.
And we really need to decode how to match your risk to your actual timeline.
Exactly.
And most importantly, how to tell a healthy, sustainable dividend payout from, well,
a manufactured yield trap.
Which is such a crucial distinction to make right now.
But just real quick, before we get into the actual mechanics of these assets.
Oh, right. The disclaimer.
Yeah, just a reminder for everyone listening that our exploration of these
tickers and strategies today is entirely educational.
Purely educational.
Right. We are here to analyze the data and the business models.
We are not giving you investment advice.
Good call.
So, let's dive into that massive flow of funds.
Because the sources show wealth managers are aggressively fleeing traditional mutual funds.
So, yeah, they are abandoning ship.
Right. And they're pouring that capital into bond ETFs specifically for the
intraday liquidity.
Yeah, having that flexibility is huge right now.
Totally.
And when you look at where the money is actually landing to very popular, you know,
quote-unquote, safe bond ETFs really stand out BND and SGOV.
And this is where you as an investor need to be incredibly careful.
Because they're not the same.
Not at all. They behave completely differently under the hood.
So, first you have BND, right? That's the Vanguard Total Bond Market ETF.
It's a classic.
Exactly. It's a massive, broad fund holding investment grade U.S. bond.
Yeah.
It has about $159.8 billion in assets just in its ETF share class alone.
That is a lot of money.
It's a behemoth.
But on the flip side, you have SGOV.
That's the I shares 0-3 month treasury bond ETF.
Right. So, very different focus.
Completely different.
SGOV is an ultra short fund.
It holds essentially cash equivalent treasury bills.
And the disparity in the money flow between these two right now
is just wild.
It was a night and day.
SGOV is actually the number one fixed income ETF by flows right now.
It's pulled in 40.7 billion dollars year to date.
I mean, it offers a 3.64% ECC yield,
a tiny 0.09% expense ratio.
And like you said, it holds T bills that mature in literally just one to three months.
Super short term.
Exactly.
Meanwhile, BND has pulled in, well, $22.3 billion, which is still a lot.
It is, yeah.
But BND carries this massive hidden risk that I think a lot of people just completely overlook
when they think of bonds as universally safe.
Duration.
Yes, duration.
Duration is, I mean, it's the silent killer in a fixed income portfolio during a rate hike cycle.
It really is.
So, think of duration kind of like a seesaw on a playground.
Okay, I like this analogy.
So, if BND has roughly six years of duration,
you can visualize that as sitting on the end of a six foot wooden board on a seesaw.
Right.
But estuary OV by comparison has a board that's only like a few inches long.
Yeah, barely a bump.
And Federal Reserve, they essentially control the fulcrum of that seesaw.
Exactly.
So, when they hike interest rates, they tilt the entire mechanism.
If you are sitting on the end of that six foot board with BND,
you are getting slammed into the ground.
Well, why does that actually happen, like mechanically?
Well, because if the Federal Reserve allows the issuance of brand new bonds
that pay, say, 5%, nobody in the open market wants to buy your older existing bond that only
pays 3%.
Unless I sell it to them at a massive discount.
Exactly, a massive, massive discount.
And let's actually do the math on that, because it's pretty brutal.
It is.
The source is point out that for a fund with a six-year duration, like BND,
if interest rates rise, just one percent.
Just one percent, yeah.
The underlying price of the ETF drops roughly 6%.
Wow.
Yeah, that completely wipes out whatever yield you thought you were safely collecting.
And the performance reality here perfectly illustrates this.
So, over the past year, despite BND offering a higher headline yield on paper, right?
Yeah.
The fund actually returned negative 0.7% in total return.
Negative return on a bond fund.
Right, because once you account for that violent price drop,
the yield doesn't save you.
But with SGOV.
Well, SGOV's bonds mature in literally weeks,
so they avoid the seesaw effect almost entirely.
They just let the short-term bills expire.
Exactly.
They expire.
They roll that cash over into the new higher-yielding bonds,
and they don't suffer the capital loss.
Which is exactly why the quote-unquote boring SGOV
delivered a positive 3.8% return over that same exact period.
Yeah, it really reinforces what is arguably the biggest mistake an investor can make right now,
which is holding years of duration while mistakenly believing it behaves like cash.
It's not cash.
It's not.
SGOV is bill for price stability and current income.
It acts as a cash proxy.
But BND inherently forces you to accept volatility.
So you only take on that level of duration
if you have a much longer timeline.
Right, and if you are actively betting on a rate cut cycle
to drive capital appreciation down the road.
Which, as we established, is not happening this afternoon.
Definitely not.
So the lesson here is you have to match your risk to your timeline.
But look, I mean, human nature is incredibly predictable.
Oh, absolutely.
If ultra short treasuries like SGOV are only yielding around what, 3.6%,
income investors inevitably start hunting for higher yields to beat inflation.
They chase the yield.
They chase the yield.
And that hunt almost always leads them directly into real estate.
Yes, and this is exactly where the actual safety of a payout
gets stress tested by the market.
Big time.
The source is contrast to very different real estate income plays to illustrate this.
You've got real estate income, which trades under the ticker O.
Yep.
And then you have agency and investment ticker agency.
All right, let's look at real estate income first.
They are a massive commercial landlord, right?
Very massive.
They own retail spaces, industrial buildings, data centers, you name it.
But their secret sauce is that they operate on what are called triple net leases.
Now a triple net lease is incredibly important to understand.
Especially right now in an inflationary environment where costs are just spiraling out of control.
So what does it actually mean?
It means the tenant, not the landlord, the tenant is legally responsible
for paying the property taxes, the insurance and the structural maintenance.
Wait, okay, hold on.
Why would a tenant ever agree to pay for a new roof on a building they don't even own?
Because it secures them long-term control over a highly desirable location.
Oh, okay.
Yeah, they get the location without having to tie up their own capital and actually
purchasing the physical real estate.
Ah, so they keep their cash free for their actual business.
Exactly.
And for realty income, this structure completely insulates them from surprise expense spikes.
Because they aren't footing the bill for the new roof.
Right, it allows them to predict their cash flow with incredible accuracy
and pay out very, very reliable monthly dividend checks.
And right now they offer a pretty sustainable 5.5% yield.
Yep, 5.5.
Okay, but then you have agency.
Oh boy, agency.
This is a mortgage rate.
They don't actually own physical buildings, right?
They buy government-backed mortgage securities.
That's right.
And they are flashing an eye-popping 14.46% yield.
It's massive.
I have to be honest, when I see a 14.46% yield in a 5% interest rate world,
my too good to be true alarm just immediately goes off.
As it should.
Is this a trap?
It is the absolute perfect case study
in analyzing whether a payout is healthy
or if it's what we call a manufactured yield.
Okay, break that down.
Well, with agency, the underlying agency mortgage-backed securities they hold
are backed by the government.
Right.
So the actual default risk,
like the risk of the everyday homeowner failing to pay their mortgage,
is virtually zero.
So what is the catch then?
Why is the market demanding a massive 14% yield for you to just hold this stock?
It all comes down to leverage and the collapse of the interest rates spread.
Okay.
See, mortgage rates operate by borrowing huge amounts of money at short-term rates.
And they use that to buy long-term mortgages.
They profit from the spread between those two rates.
But when the Fed hikes short-term rates aggressively,
like they're doing-
They're borrowing costs.
Skyrocket.
Exactly.
The spread they rely on just collapses.
And at the exact same time,
because of that duration seesaw, we just talked about.
Oh, right.
The underlying value of the mortgages they already hold plummets.
Man, so a 14% yield might look amazing on a screener,
but it is effectively hazard pay.
That's exactly what it is.
It's compensating you for the very real risk
that the underlying book value of the company
is actively shrinking while you hold it.
Precisely.
You always, always have to ask how the yield is being generated.
Right.
Is it coming from sustainable rent collection, like with real-t income?
Or is it a manufactured yield masking underlying capital destruction,
like with some of these highly leveraged mortgage rates?
Got it.
So with a mortgage rate,
you are taking on massive structural risk for a double-digit yields.
You are.
But what if we look at the absolute opposite end of the spectrum?
The sources highlight a completely different approach to income.
Yeah, this is a fun one.
There is a company called Amphenol,
ticker APH.
Yep, Amphenol.
They manufacture interconnect products, sensors, cables.
The really glamorous stuff.
Oh, yeah.
The literal nitty-gritty hardware used in aerospace,
defense, mobile networks, data centers.
And they surfaced on a very specific caviar cruise,
quality screener.
Okay, what does that mean?
It's a screener designed to find highly durable cash-genitive
compounders.
Okay, but here's the thing.
Their dividend yield is tiny.
It is.
It's just 0.97% with a payout ratio of only 19.77%.
Barely registers for some people.
Right, so wait.
You're telling me we are tracking this historic,
great dividend rotation,
where everyone is desperate for income.
Yeah.
And you want us to look at a stock paying sub 1%.
Why would an income investor even bother with that?
Because honestly, sometimes the safest dividend
is the one attached to a rapidly compounding business,
rather than a stagnant one that's just paying out all its cash
to keep investors happy.
Okay, so it's a growth play disguised as a dividend play.
Exactly.
The underlying engine of Amphenol is an absolute monster.
The numbers are crazy.
The source material shows a five-year compound annual growth rate
of 19.61% just on revenue.
Nearly 20% a year.
Right.
And their EBIT growth, which is earnings before interest in taxes,
is growing at 29.68% annually.
Meaning their profitability is actually improving
as they scale larger.
Yes.
But the source highlights another metric
that honestly stocked me in my tracks when I read it.
We ROIC.
Yes.
They list a return on invested capital or ROIC
of 73.74%.
It's incredible.
I mean, you're telling me a company making literal cables
and nuts and bolts has a 73% return on capital.
How is a hardware manufacturer pulling in software-level
margins?
It really comes down to ruthless operational efficiency
and just the essential nature of their components.
I mean, every data center needs cables.
Exactly.
And return on invested capital is simply a measure
of a management team skill at turning cash into more cash.
Right.
So for every dollar Amphenol reinvest back into its own business,
they are generating returns astronomically higher
than the market average.
They aren't wasting capital on bloated side projects.
Exactly.
In this context, the dividend isn't meant for paying
your utility bills today.
It's not a cash cow.
No, it functions as a signal of immense financial discipline.
A management team that pays a consistent dividend
while achieving 73% ROIC.
They are mathematically proving that their earnings
are real, tangible cash.
It's not just clever accounting fiction.
Not exactly.
But there is a massive hurdle here
and it jures in the valuation.
You have to pay up for it.
You really do.
You have to pay a massive premium
to own that kind of quality.
The stock is currently trading at a trailing price
to earnings ratio of 36.53.
Which is steep.
That is incredibly expensive for an industrial hardware company.
It is, yeah, if you are only looking backward.
OK.
But remember, growth stocks are priced on the future.
They're forward PE, which is based on what analysts
expect them to earn next year,
drops all the way down to 12.04.
Oh, wow.
That's a huge drop.
Right.
The market is pricing in massive future growth.
But the entire thesis for holding a stock
like this rests on those forward growth estimates
actually coming true.
Right.
And if they stumble.
Oh, if they stumble, that valuation
multiple correct very sharply.
So with Amphenol, you're paying
a huge premium for future growth.
But if you're an investor who doesn't
want to rely on future estimates
panning out perfectly, you're probably looking
for a discount today, which makes sense.
And ironically, the massive rate hikes
that are hurting bonds are actually
putting some of the most reliable dividend
pairs in the world on sale right now.
Yes, we are talking about the bedrock
of traditional income portfolios here.
Big food and consumer staples.
Exactly.
Specifically companies like PepsiCo and McDonald's.
The current market environment has really
punished these highly defensive stocks.
It's created a rare valuation discount.
Definitely.
So PepsiCo, for instance, is trading
around $136 a share right now
against an estimated fair value of roughly $169.
That's a nice margin of safety.
It is.
And it currently offers a 4.26% yield.
And importantly, it is a true dividend
king.
And that distinction really matters.
To be a dividend king, a company must
have raised its dividend for 50 consecutive years.
Half a century.
Right.
That means they survived the 1970s inflation crisis,
the dot-com bust, the 2008 financial crisis,
and a global pandemic without ever
once cutting their payout.
Which is wild to think about.
And the sources provide this brilliant real money case study
of how everyday investors are exploiting this exact dynamic
right now.
Yeah, the example with Lanny.
Right.
There is this investor named Lanny, who systematically
deployed $1,048 in six cents in early September
to dollar-cost average into this dip.
And dollar-cost averaging.
I mean, it is such a powerful psychological and mathematical tool.
It takes the emotion out of it.
Completely.
Instead of trying to guess the absolute bottom of a falling
market, which, let's be honest, is impossible.
Lanny bought and measured increments.
Let's actually break down the math of his buys,
because it's super practical.
So he bought two shares of Pepsi in early September
at an average price of $138.87.
OK.
Then he turned to McDonald's.
Now, McDonald's has 49 years of dividend increases.
And they're actually expected to cross into dividend
king status this very month.
Huge milestone.
Yep.
Lanny bought three shares of McDonald's over a 10-day period,
but he did it in tranches.
That's more.
One share at $261.60, another at $255.56,
and a third at $253.16.
And by breaking up his purchases like that,
that discipline buying lowered his average cost on McDonald's
down to roughly $256, which locked in a very solid yield
of about 2.94% on those shares.
So by doing this, Lanny added $34 in forward income
to his portfolio at a blended 3.26% yield.
Not bad for $1,000.
Not at all.
And he's using DRB, dividend reinvestment
to automatically buy fractional shares, continually compounding
those payouts toward his ultimate goal
of holding 100 shares of each company.
It's a master class, honestly, in utilizing market volatility.
Because when interest rates rise in those risk-free bond yields
suddenly look attractive, massive
institutional money often rotates out of these dividend
stocks mechanically.
Just algorithms selling.
Exactly.
And that pushes their share prices down.
That is precisely when disciplined, long-term income
investors can step in and buy high-quality cash flows
at a major discount.
But I do want to flag a crucial contrast
I found in the sources.
Oh, with Courage.
Yes.
So while Pepsi has a very safe 73.4% payout ratio,
meaning they pay out about 73 cents in dividends
for every dollar of profit they earn,
leaving plenty of room for error.
Another stock in the exact same sector,
Courage Doctor Pepper, or KDP, was flagged for a severely
stretched 88.2% payout ratio.
Yeah, that's right.
Very tight.
And that's alongside some corporate integration risks.
So it's not just about finding a recognizable brand name
that happens to be down in price.
No, definitely not.
It's about verifying they have the safety buffer
to actually keep paying you in macroeconomic conditions
tighten.
Right, the payout ratio is your margin of safety.
Exactly.
A recognizable brand name on a soda can
does not automatically grant immunity
from bad balance sheet management.
Great way to put it.
So, OK, if those US staples are on sale, I'm wondering,
can we find even bigger discounts by looking overseas?
Oh, absolutely.
Like, how do we diversify an income stream
away from domestic interest rate cycles entirely?
Well, that strategy brings us to American depository receipts
or ADRs.
OK, so ADRs, these are essentially dollar listed certificates
issued by US custodian banks, right?
And they represent actual shares in foreign companies.
That's exactly it.
So they allow you to buy international stocks
right on standard US stock exchanges,
just like you would buy a share of Apple or Ford.
And the primary appeal here right now is the yield differential.
It's huge.
It is.
Compared to the S&P 500s, historically,
meager 1.1% dividend yield, international blue chips
offer a significant step up.
The sources highlight some pretty massive household names, too.
Yeah, they do.
You've got Nestle at roughly 3.5% yield,
Shell and Unilever are both yielding around 4.0%.
And Toyota Motor is at 3.5%.
See, I totally get the appeal of that.
Securing a 4% yield on a massive global energy company
like Shell, and I don't even have
to navigate opening a foreign brokerage account.
Right.
It's very convenient.
But there is always a friction cost with this stuff, right?
Always.
Starting with the banks actually issuing these certificates.
Yes.
The first hurdle you run into is pass through fees.
OK.
The US custodian banks that hold the actual foreign shares
and issue the ADRs, they charge a management fee.
Naturally.
Now it's usually small, run one to five cents per ADR
per dividend payout.
OK, a few cents doesn't sound terrible.
It doesn't.
But if you own thousands of low-priced shares,
that fee can quietly erode a significant portion
of your total return.
Being nickel and dime by the custodian bank,
I've figured as much.
Yeah, it adds up.
And there has to be a tax trap here, too.
Is a foreign government taking a bite out of that yield
before it ever hits my brokerage account?
They absolutely are.
Yeah.
Foreign governments will often withhold a portion of your dividend
for taxes before it ever leaves their borders.
How much are we talking?
Sometimes up to 35%, depending on the country's specific laws.
Yes.
Yeah.
Now, the US does have tax treaties with many nations
that can reduce this withholding rate.
OK, that helps.
And if you hold these in a taxable account,
you might be able to claim a foreign tax credit
on your US return.
But it introduces a major layer of administrative complexity.
Exactly.
You're going to be dealing with extra tax forms.
Ouch.
And I assume since Shell or Toyota isn't operating primarily
in US dollars, I am also at the mercy of the exchange rate
when that dividend finally gets converted and paid out to me.
That is the third and, honestly, often
the most volatile catch, currency risk.
Right.
Even though you buy and sell the ADR in US dollars
on a US exchange, the underlying foreign company
is declaring and paying its dividend in euros or yen
or Swiss francs.
So when they convert it?
When that foreign currency is converted to dollars to pay you,
the daily exchange rate dictates your actual return.
Got it.
So if the US dollar is very strong relative to the yen,
for example, your payout from Toyota
shrinks during the conversion.
Because your dollars are worth more.
Right.
But if the dollar weakens, your payout actually
gets an artificial boost.
So applying the exact same rigorous fundamental analysis
as you would to a domestic stock is critical.
Absolutely.
But you have to ensure the diversification benefits
actually outweigh those added frictions
of custodian fees, foreign taxes, and currency fluctuation.
Precisely.
ADRs are a fantastic tool to build a truly global income
strain, but you have to go and fully
aware of the mechanical drag on those yields.
So let's tie this entire deep dive together.
We started with the reality of a 5% treasury yield
and Federal Reserve poised to move rates today, creating
a staggering $446 billion wave of money
sloshing into fixed income.
It's a historic shift.
It really is.
And we've seen that successfully
navigating this great dividend rotation
requires extreme discipline.
You can't just chase whatever ticker yields
the most on a screen.
No, that's how you get burnt.
It really distills down to two major practical takeaways
from all the data we looked at.
OK, what's the first one?
First, you absolutely must match your risk
to your specific timeline.
Right, the SGOV versus BND debate.
Exactly.
If you need near-term stability and liquidity,
ultra-short cash proxies like SGOV
are doing exactly what they are mathematically designed to do.
But you only take on the duration risk of a broader fund
like BND if you have a long time horizon.
Right.
And if you can stomach the violent volatility of the seesaw.
Makes sense.
And what's the second takeaway?
Second, use the broader market's fear to your advantage.
By the dip.
Use volatility to dollar cost average
into high-quality, sustainable payouts.
Look for companies with incredibly strong capital
allocation like Amphenol or wide safety margins
in their payout ratios like Pepsi, just like Lanny did.
And avoid the temptation of a manufactured yield trap
at all costs.
14% is not always 14%.
Exactly.
Just because a mortgage rate yields 14%
does not mean it is paying you 14% safely.
You have to understand how the underlying asset
reacts to the cost of capital.
Which leaves us with one final thought
for you to mull over as we wrap up.
Let's hear it.
We've spent this entire time tracking
where the smart money is migrating today.
But take a hard look at your own portfolio tonight.
Look at your actual holdings.
Exactly.
Look at the specific tickers you hold.
Are you holding something because it
paid you well in yesterday's low rate environment?
Or because its business model can actually
survive the gravity of tomorrow's 5% world.
It's a tough question to answer.
It is.
Are there hidden duration traps sitting in your portfolio
right now that you mistakenly thought
were as safe as cash?
Because when the Fed finally moves the fool
from this afternoon, it might be too late to find out.