The Coca-Cola Company (KO), PepsiCo, Inc. (PEP): Are Dividend Investors Heading for a Slaughter?

For years, income-hungry investors have had to endure the Federal Reserve’s policy of keeping interest rates near record lows. Although that’s been positive for homeowners and other major borrowers, savers have borne the brunt of the cost of zero-interest rate policy, as the amount of cash they used to get from bank CDs, savings accounts, and bond investments has plunged.

In response, more investors than ever are turning to dividend-paying stocks. With dividend yields that in many cases greatly exceed what you can get on bonds, dividend stocks have become the only viable option for those who rely on regular income from their investment portfolios to meet their needs. Yet as more money flows into dividend stocks, higher valuations raise the question of whether they can provide good total returns — or whether buying dividend stocks right now is like following the herd off a cliff.

The search for yield
Even with the stock market at all-time highs, money continues to flood into dividend stocks. As an article from IndexUniverse highlighted on Friday, income-starved investors bought huge amounts of new shares in dividend ETFs Vanguard High Dividend Yield (NYSEMKT:VYM) and iShares High Dividend Equity (NYSEMKT:HDV) last week. Inflows into the Vanguard ETF amounted to more than $1 billion, boosting the size of the fund by 20%. The smaller iShares ETF saw a 10% rise in its overall assets under management, as more than $280 million got added to the fund.

What’s noteworthy about the moves is the emphasis on the highest yields possible. Vanguard has another dividend ETF that focuses more on long-term dividend growth than immediate yield, and that fund has generally been more popular than its high-yield dividend ETF. But now, more investors are piling into the higher-yielding fund.

What a falling bond market may do to dividend stocks
Low bond yields encourage investors to move to higher-yielding stocks. But over the past six months, the yield on the 10-year Treasury has bounced off its summer 2012 lows, rising from below 1.5% to above 2% recently. If bond yields continue to rise, will fickle investors move back to the bond market?

The answer is far from clear. On one hand, higher bond yields will allow conservative investors to get the income they need while moving back into more comfortable territory. Bonds tend to be less volatile than stocks, and if bank CDs start to raise their rates in line with Treasuries, the added benefit of FDIC insurance protection will undoubtedly lure some investors to pull their money out of dividend stocks.