The Latest Sign That Bond Yields Are Completely Ridiculous

Income-hungry investors have taken it on the chin for years. With the Federal Reserve's low interest rate policy, bond yields have fallen further than nearly anyone expected. And after last week's big European scare, rates fell to their lowest levels on record, with 10-year yields dropping below 1.5% before rebounding a bit in recent days.

As several of my fellow Fools have already pointed out, low bond yields make dividend-paying stocks look a lot more attractive. For a while now, the S&P 500's dividend yield has exceeded the yield on the 10-year Treasury. But lately, rates have gotten so low that even small-cap stocks briefly joined their larger counterparts by having dividend yields exceeding what you could get from a 10-year Treasury note.

This doesn't happen every day
Small-cap stocks aren't exactly known for their high dividend yields. In contrast to bigger, more mature companies that have better-established business models and tend to generate more free cash flow, small-cap companies typically have to retain as much as they can in order to grow their businesses and invest in new money-making opportunities. Many small-cap stocks pay no dividends at all, while many others make only token payments to get on the radar screens of income-seeking investors.

As a result, the current situation is extremely rare. As Barron's pointed out earlier this week, the only times this has happened in the past couple of decades were during the financial crisis -- when the market was plumbing ever-lower depths in preparation for one of the biggest moves higher in stock market history -- and last September, right before stocks went on an amazing six-month bull run.

In situations like this, what's worked well in the past is simply to buy a basket of small-cap stocks. Because these conditions tend to occur when stock prices are low and bond prices are inordinately high, simple reversion to the mean produces some pretty strong returns even for the broadest small-cap ETFs.

Finding big yields from small companies
But another way you can try to take advantage of low bond yields is to seek out small-cap stocks that have inordinately high yields. With high-yielding stocks, you don't even need share prices to rise at all in order to capture a decent return.

Unfortunately, many high-yielding small caps come with substantial risks. For instance, SUPERVALU (NYS: SVU) has been trying to turn around its grocery-store chain business for quite a while, but its most recent round of restructuring has created big losses and an uncertain future. But if you believe the changes will bear fruit, then the company's rock-bottom valuation and 8% yield give you plenty of potential upside.

Similarly, Seaspan (NYS: SSW) reported analyst-topping earnings in its most recent quarter, along with plans to pay $1 per share in dividends this year, equating to more than a 6% yield at current prices. The containership company has had to deal with a very tough industry environment, but arguably, investors are getting fair compensation for the risks involved.

Other small caps are more mature than their size may suggest. EarthLink (NAS: ELNK) is a well-known Internet service provider from the dial-up days, but its business still generates substantial cash flow despite concerns that its long-term future doesn't look bright. Another example is WD-40 (NAS: WDFC) , which rests its fortunes largely on a single product, but that's enough to generate a 2.4% yield that's been dependable for quite a while.

Finally, you can sometimes find companies somewhere between their growth phase and the more mature part of their lifespan. True Religion's (NAS: TRLG) biggest growth spurt may be behind it, but the company is still small enough to have potential to move on to the next level. Yet that hasn't stopped it from starting to pay a dividend yielding nearly 3%.

Look closely at stocks of all sizes
Accepting 1.5% for the next 10 years simply doesn't make much sense, now or ever. With a wide variety of small-cap stocks paying well in excess of 1.5%, you owe it to yourself to take a closer look at investments that can actually make you money over the long haul.

Great dividend stocks come in all sizes. Take a look at our special report on dividends and learn the names of nine dividend dynamos with big potential. It's free, so click here and get your copy today!

At the time thisarticle was published Fool contributor Dan Caplinger loves big potential in small packages. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of SUPERVALU and Seaspan. Motley Fool newsletter services have recommended buying calls on SUPERVALU and creating a covered straddle position in Seaspan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is just the right size.

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