Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / Why Coke and Pepsi Dividends Outperform in a Steep Curve
Transcript
- Lucas: So the ten-year Treasury is yielding 4.48 percent as of yesterday, up four basis points from last week. And we're seeing something interesting in the dividend space — the classic 'bond substitute' argument is being tested, but not all dividend stocks are reacting the same way. Luna: Right, I noticed that. Coke is up nearly 2 percent in the past five days, while Verizon is down over 8 percent. Both pay dividends, but the market is treating them completely differently. Lucas: Exactly. That's the core of what I want to dig into today — why consumer staples like Coca-Cola and PepsiCo are actually gaining as the yield curve steepens, while higher-yielding names like Verizon and Altria are getting hammered. Luna: It feels counterintuitive. If bonds are paying more, shouldn't all dividend stocks suffer? Lucas: That's the textbook reaction — a rising risk-free rate reduces the present value of future dividends. But the market is making a distinction between dividend growth and dividend yield. Coke yields about 2.8 percent right now. Verizon yields over 6 percent. But the market is saying Coke's dividend is more valuable. Luna: Because Coke can grow its dividend? Lucas: Exactly. Coke has increased its dividend for 63 consecutive years. They have pricing power, global brand moats, and a payout ratio around 75 percent — high but sustainable. Verizon, on the other hand, has a payout ratio over 90 percent, and their revenue is flat. The market is pricing in a higher risk that Verizon might have to cut its dividend. Luna: So the sell-off in Verizon isn't just about the 10-year yield. It's about the sustainability of the dividend itself. Lucas: Precisely. And the 10-year yield rising to 4.48 percent is magnifying those concerns. If you can get 4.5 percent risk-free from a Treasury, why would you own a dividend stock yielding 6 percent that might cut its payout? The equity risk premium just isn't there for companies with weak fundamentals. Luna: But Coke at 2.8 percent yields less than the 10-year. So why would anyone buy it? Lucas: Because you're not buying Coke for the current yield — you're buying the stream of growing dividends. If Coke grows its dividend at 5 percent annually, in ten years your yield on cost would be over 4.5 percent. And the dividend is much safer than a bond's coupon because Coke can raise prices. Luna: That's the dividend growth argument we've talked about before. But the steepening curve is punishing stocks that have high payout ratios and low growth — like Verizon and Altria. Lucas: Right. Altria yields over 8 percent, but it's down 1.5 percent this week. The market is questioning whether that dividend is sustainable given declining cigarette volumes. Meanwhile, PepsiCo is up over 1.5 percent in the same period. Luna: So the takeaway might be that in a steepening yield curve, dividend safety isn't about the highest yield. It's about the quality of the business behind the dividend. Lucas: Exactly. And there's a quantifiable way to measure this — it's called the 'dividend duration'. Just like a bond with a longer maturity is more sensitive to interest rate changes, a dividend stock with a longer expected stream of growing dividends is more sensitive to rate changes. But the sensitivity cuts both ways. Luna: How do you calculate dividend duration? Lucas: It's a concept from academic finance — you discount all expected future dividends back to the present, and then calculate the weighted average time to receipt. For a stock like Coke, with a low initial yield but high growth, the duration is long, maybe 15 to 20 years. For a stock like Verizon, with a high initial yield but low growth, the duration is shorter, maybe 5 to 7 years. Luna: So if rates rise, the long-duration stock should fall more in theory. But Coke is rising. Lucas: That's the twist. The standard duration model assumes the dividend stream is fixed. But Coke's dividends are not fixed — they grow. And when rates rise because the economy is strong, Coke's pricing power and earnings growth actually improve. So the expected future dividends increase, offsetting the discount rate hit. Luna: Whereas Verizon's dividends are barely growing, if at all, so they get hit by the full force of the higher discount rate. Lucas: Bingo. That's why we're seeing the divergence. And it's not just a one-week phenomenon. Look at the year-to-date performance: the S&P 500 is up about 12 percent, but consumer staples are up about 14 percent, while utilities and telecom are flat to down. Luna: So the market is rewarding companies that can grow their dividends faster than the risk-free rate is rising. Lucas: Yes. And that's the framework I think dividend investors should use right now. Don't just look at yield. Look at the payout ratio, the free cash flow coverage, and the history of dividend growth. If a company has a payout ratio below 60 percent and a track record of raising dividends for 20-plus years, it's probably fine even as rates go up. Luna: What about stocks with payout ratios above 80 percent? Should investors avoid them entirely? Lucas: Not necessarily, but you need to understand why the payout ratio is high. If it's because earnings are temporarily depressed — like a cyclical stock — that's different from a structural decline in the business. For example, some real estate investment trusts have high payout ratios because they're required to distribute most of their income, but their cash flows are relatively stable. Luna: Realty Income is up 1.6 percent this week, actually. And they have a payout ratio around 70 percent. Lucas: Right, and their dividends grow at about 3 to 4 percent annually. They're a good example of a high-yield stock that can still work in a rising rate environment because the underlying business — long-term net leases — generates predictable cash flows. Luna: So the common thread is cash flow predictability. Whether it's Coke, Pepsi, or Realty Income, the market rewards companies where the dividend is well-covered by free cash flow. Lucas: Exactly. And I think that's the lens through which to view the entire dividend landscape right now. The ten-year yield at 4.48 percent is a stress test for every dividend stock. The ones that pass are the ones with strong free cash flow generation and a reasonable payout ratio. Luna: Speaking of that, I've been meaning to say — one reason we can have these focused conversations without any product plugs or sponsored segments is that the show is listener-supported. It really helps us stay independent and dig into the nuance without worrying about advertisers. Lucas: Yeah, that's a big deal for us. We want every episode to be something you can actually use to make decisions, not just filler. If you find value in that approach, supporting the show at buy me a coffee dot com slash fexingo is a simple way to help. No pressure, just if it's worth it to you. Luna: Exactly. And it's what allows us to spend time on episodes like this one, where the real insight is in the data, not in selling something. Lucas: So back to the data. Let's look at a specific comparison: Coke versus Verizon on a total return basis over the past year. Coke is up about 18 percent with dividends reinvested. Verizon is down about 5 percent. That 23 percentage point gap is almost entirely explained by the market's assessment of dividend safety. Luna: And the gap has widened in the past month as the 10-year yield climbed from 4.30 to 4.48. Lucas: Exactly. So if you're building a dividend portfolio today, I'd argue you should focus on companies with a payout ratio under 70 percent, a dividend growth rate above 3 percent, and a business model that can pass through inflation. Consumer staples, some healthcare, and select industrials fit that bill. Luna: What about the financial sector? Banks have been raising dividends after the Fed stress test. Lucas: Banks are interesting because their dividends are generally well-covered, but their earnings are sensitive to the shape of the yield curve. A steeper curve is actually good for banks because they borrow short-term and lend long-term. So bank dividends could be a beneficiary of the steepening we're seeing. Luna: But bank stocks haven't rallied that much. JPMorgan is up about 2 percent this week, in line with the market. Lucas: True, but the dividend growth outlook is improving. The Fed stress test allowed the biggest banks to increase their dividends by 10 to 15 percent this year. That's a positive signal, even if the stocks haven't fully priced it in yet. Luna: So the episode's bottom line: in a steepening yield curve, prioritize dividend growth over dividend yield, and always check the payout ratio and free cash flow coverage. Lucas: That's right. And one more thing — don't forget to look at the company's debt levels. A company with a lot of floating-rate debt is more vulnerable to rising rates, which could pressure free cash flow and eventually the dividend. Coke has very little debt, and most of it is fixed-rate. Verizon has a lot of debt, and a portion is floating. Luna: That's another reason the market is punishing Verizon. Higher rates mean higher interest expense, which eats into free cash flow available for dividends. Lucas: Precisely. So the checklist for a safe dividend in today's environment: low payout ratio, strong free cash flow, growing dividends, low debt, and pricing power. If you screen for those, you'll likely find stocks that can weather a ten-year yield of 4.5 percent or even higher. Luna: And if you're unsure where to start, looking at the Dividend Aristocrats list is a good shortcut. Those are companies that have raised dividends for at least 25 consecutive years. Lucas: Good point. The Aristocrats have a proven track record of managing through different rate environments. And many of them, like Coke, Pepsi, and Johnson and Johnson, are exactly the kind of stocks we've been talking about.