RISING INTEREST RATES: LOOK AT HIGH-YIELD DIVIDEND STOCKS

Market pundits including yours truly, have been talking about the Federal Reserve raising interest rates for what seems like an eternity. With rates at record low levels, it makes sense that the only direction they can go is higher. The question is not only when they will start to rise, but how investors should position their portfolios for the much anticipated new reality.

Conventional wisdom says that as interest rates rise, interest or dividend paying investments will drop. Why? Let’s say that you own an IBM bond that yields 1.5% per year. If rates are at zero, then 1.5% is a good deal and there is demand for that bond. If rates rise and I can get 2% on a government insured deposit, why would I bother with the IBM bond? What then happens is that the price of the bond falls as there is a lack of demand.

Based on that basic principle it would stand to reason that stocks that pay dividends would suffer the same fate. After all, if you get a 2.65% dividend from Microsoft stock, that’s great compared with a zero interest rate on a deposit. But if rates move higher that 2.65%, it is much less intriguing and the price of the stock could drop.

Pace of rate rise

Interestingly the theory regarding dividend stocks is not at all crystal clear. In fact if you take a look at some historical figures you will see that high-yielding dividend paying stocks may be the way to go.

According to research from Global X, since 1960 there have been 10 cycles of meaningful interest rate raises. In 3 of those cycles dividend stocks underperformed the broader market. In 8 of the periods there was significant over performance from these stocks.  Generally those numbers are not too persuasive. I wouldn’t generally advise clients based on that kind of data because it isn’t overwhelmingly pointing to potential success. But if you dig a bit deeper into the data an interesting trend stands out.

According to Global X, “The three instances of underperformance occurred in periods with among the most rapidly increasing interest rates.” This means that in the three periods when dividend stocks underperformed the market the Federal reserve raised interest rates aggressively in a short amount of time. In the seven cycles where high-yielding dividend stocks outperformed, the Federal Reserve raised rates over a prolonged amount of time in a much less aggressive fashion. If you were to poll economists and market analysts as to how they view the pace of the upcoming rate hikes, it will be nearly unanimous that it will be a slow, drawn out process. If that is true and we learn from history, high-yielding dividend stocks may very well be the way to invest.

Good sign

In general a dividend strategy has merit.  Solid companies with long histories of paying dividends (like Johnson & Johnson), tend to be companies doing well and generating profits and substantial cash flow, and they are returning that money to shareholders.

Mark Mobius, the famed executive chairman of the Templeton Emerging Markets Group said in Seekingalpha.com, “Dividends are very important, not just because investors like to receive the income they can potentially offer. We think dividends can be an indicator of good corporate governance. In the past, most companies in emerging markets preferred to put profits back into their businesses, rather than pay it out to shareholders. But today more are engaging in dividend payouts, and we think this is a good thing. If a company is giving dividends to shareholders and still has enough cash left over to expand and make needed capital investments, it’s very positive in our view.”

While Mobius is speaking about emerging markets, the same argument can certainly be made in relation to developed markets like in the U.S.

There is certainly value in dividend-paying stock investing if done in a context that helps you meet your goals. It also may be the prudent way to invest when interest finally rise. Speak with your financial advisor to learn how to incorporate high-yielding dividend paying stocks in your portfolio.   

 

 

The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.