Why rising yields will not stymie dividend stocks

Why rising yields won’t stymie dividend stocks

Focus on sectors and styles, and avoid the highest payout

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By Jonathan Burton, MarketWatch

SAN FRANCISCO (MarketWatch) — A recent bout of rising U.S. interest rates has beaten up on dividend-paying stocks, rattling shareholders who had been enjoying regular income and higher prices from these so-called defensive equities.

But the end of rock-bottom rates shouldn’t be the death of dividend strategies. Indeed, some market professionals say investors just need to be more selective about the types of dividend stocks they pursue.

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“Dividends are a good long-term theme,” says Russ Koesterich, chief investment strategist at BlackRock Inc. But, he adds, changing conditions just mean investors will have to look a little harder for opportunities.

The Federal Reserve in the past two months has made statements indicating it plans to begin unwinding its massive bond-purchasing program, perhaps later this year. That’s why dividend stocks stumbled in May and June, and why investors can expect more volatility should Treasury yields continue on an upward trajectory.

Higher bond yields make the lower interest rates on older bonds less attractive — and eat into the appeal of stocks that were bought largely for their dividend yield.

“People see other alternatives and withdraw money from dividend stocks,” says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

But dividend stocks as a group have, on average, outperformed non-dividend peers during periods when the Federal Reserve nudges interest rates higher, though not by much. A study by Ned Davis Research found that dividend payers in the Standard & Poor’s 500-stock index (SNC:SPX) returned 2.2% annualized during such times, while non-dividend stocks in the index gained 1.8%. (By contrast, dividend stocks trounce non-dividend shares in “neutral” or “easing” periods when interest rates decline.)

Here are strategies and suggestions from market professionals who argue there is still room for growth in the right kinds of dividend stocks:

Highest isn’t tops

For starters, some say, avoid the highest-yielding stocks. The yield-rich utilities sector of the S&P 500, for example, lost 2.7% from the beginning of April through June, compared with a 2.9% gain for the benchmark itself.

“High dividend yield doesn’t give you a place to hide in an environment that doesn’t favor equities,” says Sharon Hill, head of equity quantitative research and analytics at Philadelphia-based portfolio-management company Delaware Investments.

Despite their high yields, utilities, telecommunications and other bond-like areas of the stock market tend to be slower-growing and debt-laden. Their dividend issuance relative to earnings — the “payout ratio” — is often extremely high, leaving little room for increases.

Think about sectors

Focus on companies in sectors closely tied to economic health and whose earnings and dividend payouts are growing. Technology, industrials, health care and other economically sensitive sectors fit this bill. In an improving economy, these cash-rich companies will be able to raise their dividends to keep pace with inflation. Accordingly, they’re a better hedge against rising rates than more financially constrained businesses.

“Tech companies are paying good yields,” says Charles Rotblut, vice president at the American Association of Individual Investors. Among his favorites: Qualcomm Inc. (NASDAQ:QCOM) , Texas Instruments Inc. (NASDAQ:TXN) and Cisco Systems Inc. (NASDAQ:CSCO) , which recently sported yields ranging from about 1.8% to 2.5%.

...And economic cycles

Cyclical stocks have been the market’s best performers during lengthy periods of rising rates. Research firm Birinyi Associates studied nine such cycles since 1962 and found that the technology, industrial and materials sectors averaged double-digit gains in the six months after interest rates started to rise, while the utilities and telecommunications sectors lost ground and consumer staples lagged the S&P 500.

Given that history, investors using exchange-traded funds and mutual funds that invest in dividend-focused stocks should be mindful of whether the overall portfolio is cyclical or defensive.

Challenge for funds

A climate of higher rates will challenge more than just individual investors. Many mutual-fund managers and other investing professionals have never experienced a prolonged stretch of rising yields, and not all will rise to the occasion.

Dividend-growth funds with a high concentration of cyclical technology stocks are particularly suited to the times. By contrast, many other dividend funds emphasize higher current income and are skewed toward consumer staples, utilities, telecom and other high-yield, defensive sectors.

The popular iShares Dow Jones Select Dividend Index (NAR:DVY) exchange-traded fund, which includes dividend growth in its stock-selection criteria, had almost 30% of assets in utilities and only 3% in technology at the end of June.

In contrast, the WisdomTree U.S. Dividend Growth ETF (NASDAQ:DGRW) divides about 60% of its portfolio equally among technology, industrials and consumer-discretionary stocks.

An actively managed mutual fund with expenses comparable to the WisdomTree ETF and even cheaper than the iShares Select Dividend ETF is Vanguard Dividend Growth (MFD:VDIGX) . The $15.3 billion fund, which recently yielded about 2.1%, had committed 13% of assets to technology stocks and less than 2% to utilities as of May 31.

Says BlackRock’s Koesterich: “Dividend strategies need to shift. People need to become more selective.” Otherwise investors may find that instead of changing with the times, the times change them.