Rate cuts are coming. But will dividend stocks care?

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Many observers are still expecting central banks to cut their key interest rates in the months ahead, which could put more emphasis on dividend-paying stocks.

But just what sort of dividend bonanza should we expect? The answer, unfortunately, could be disappointing.

Though yields on guaranteed investment certificates (GICs) and money market funds will decline further with additional rate cuts, income-oriented investors who scramble for higher-yielding alternatives might not like what they find in the equity universe.

That’s because many popular dividend stocks that deliver reliable distributions and annual increases now have high valuations and low yields, following a two-year ripping rally. And the few remaining stocks with attractive dividend yields come with risk.

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The glory days for buying dividend stocks began in 2021, when inflation stirred and the U.S. Federal Reserve and the Bank of Canada responded with aggressive rate hikes over the next two years.

The yield on the 10-year U.S. Treasury bond rose above 5 per cent by October, 2023, up from about 1 per cent at the start of 2021.

Dividend stocks faced tough competition for investor affection during that period, given that once-lowly Canadian GICs began to offer yields of more than 5 per cent over, say, a five-year term.

In many cases, the shares of blue-chip dividend-paying companies slumped, driving yields higher.

But look what has unfolded since then, as inflation cooled and investors reacted to rate cuts and anticipated more of them: Dividend stocks surged.

The S&P/TSX Canadian Dividend Aristocrats Index TXDV, which tracks stocks that have maintained or raised their payouts for five consecutive years, notched another record high on Thursday.

The index, dominated by financials, energy producers, real estate investment trusts and utilities, has risen 46 per cent from its recent low in 2023.

This isn’t just a Canadian phenomenon.

In the United States, where interest rates are significantly higher than in Canada, the S&P 500 Dividend Aristocrats Index has gained a respectable 23 per cent since 2023.

As share prices rise, yields sink. The dividend yield for Hydro One Ltd. H-T is just 2.7 per cent and Royal Bank of Canada’s RY-T yield is under 3.1 per cent, which seems low for stocks prized for their dividends.

TC Energy Corp.’s TRP-T yield is higher, at 4.7 per cent – but that’s down from a recent peak of 8.9 per cent in 2023. The company stands to benefit from Ottawa’s decision to fast-track major projects, which could include a pipeline.

In theory, additional rate cuts should make dividends look even more attractive as income-generating alternatives fade.

There is some good news here (well, good in an investing sort of way): Employment numbers have turned weaker, which has raised the odds of rate cuts.

Ali Jaffery, a senior economist at Canadian Imperial Bank of Commerce, expects the Fed will cut its key rate next week and again in October, despite sticky inflation in August.

Douglas Porter, chief economist at the Bank of Montreal, expects the Bank of Canada will cut its key rate three times through the start of 2026.

But the potential impact on dividend-paying stocks is murky.

Not only are yields already low, but lofty price-to-earnings ratios suggest that stocks are fully valued based on expected profits.

Canada’s Big Six banks are trading near the top end of their 10-year valuation range, while dividend stalwarts such as Fortis Inc. FTS-T and TC Energy are well above their 10-year averages, according to data from S&P Global Market Intelligence.

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You can still find attractive yields, and low valuations, among Canadian telecom stocks such as BCE Inc. BCE-T and Telus Corp. T-T (full disclosure: I own both stocks).

But the sector’s sensitivity to interest rates is now questionable, despite being known as bond proxies. That’s because key players are struggling with more important matters, such as high debt levels and intense competition, which has weighed on their share prices.

Canadian energy producers have been rewarding investors with rising dividends, rather than spending gobs of money on expansion. But the stocks are still susceptible to falling oil prices, and there is always the risk of companies discarding their discipline and raising their output.

Lastly, some REITs with attractive yields are still facing an office market with stubbornly high vacancy rates, while shopping malls are dealing with a challenging retail landscape. Weaker economic activity and falling employment numbers won’t help matters.

It has become clear that interest rate cuts are coming, and as soon as next week. For dividend stocks, though, the cuts look like old news already.