Time to dump high-dividend stocks?
With interest rates near zero, investors have been desperately seeking yield. As a result, one of the hottest trades for investors over the last four to five years has been buying large companies that pay high dividends.
Looking for another reason for the run-up in dividend stocks?
Because investors were scared out of their minds after the financial crisis and decided the safest thing to invest in was to buy quality names that they recognized. After all, the global economy may have been in ruins but people were still going to wake up and brush their teeth every morning. Investors have turned to blue-chip companies, like Johnson and Johnson US:JNJ or Kimberly Clark US:KMB that they know and that pay dividends significantly higher than they can get on a bond or bank deposit. It’s gotten to the point that high-paying dividend stocks have turned into an alternative to bonds.
When you start seeing headlines like, “5 dividend stocks for a successful retirement” or “Retirement strategy: Buy any dips in dividend winning stocks,” warning signs should start to flash. A basic rule in investing; nothing goes up in a straight line forever. I am not against dividend stocks, it’s just that when they become the panacea for all investors I get worried.
New reality
Last month’s comments made by new Fed Chairwomen Janet Yellen that rates may start heading up six months after the end of the QE program, creates a new reality for investors. As rates start to move higher dividend stocks have the potential to lose their luster as their 3%-4% yield isn’t as interesting as it was in a zero rate environment. Investors should start planning and get their portfolios in tune with a higher rate environment. I know many of you will say that it’ll be at least another year before any of this happens due to a lagging economy, but keep in mind that markets start pricing in these types of macro-events a good six to eight months before they happen, and the economy is improving albeit anemically.
What to do?
Flashback a year ago when all the “Taper” talk started. It didn’t take long for bonds to get hammered, as the 10-year U.S. Treasury bond yield jumped from 1.5% to around 3.5%. Bondholders saw their holdings drop by 5%-10%, not exactly the kind of volatility you would expect from a “conservative” investment. If the Fed actually raises rates the carnage could be worse. The question then is what to do?
For the fixed-income allocation of the portfolio the first tip is to go global. Believe it or not investing in foreign bonds provides both value and stability. It’s all about the business cycle.
Alison Martier, Senior Portfolio Manager of Fixed Income at AllianceBernstein, writes, “A U.S.-only bond investor is affected by one business cycle, one yield curve and a single monetary policy. As long as rates were falling, that seemed like a good thing. Not so these days. Going global diversifies an investor’s interest-rate risk — and brings many other potential benefits. Although different countries’ economic cycles, business cycles, monetary policies and yield curves may briefly align, over long periods they’ve not been highly correlated. The array of country returns differs significantly each year. And so do future opportunities — and risks. If that sounds worrisome, think again: Your own country is part of this mix, and if you’ve got a home-centric portfolio, it’s riding rough seas without ballast.
While we may think foreign bonds are speculative and very volatile, surprisingly they’re not. I interviewed Douglas Peebles, Chief Investment Officer and Head of Fixed Income at Alliance Bernstein, for my book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing, and he told me, “Since 1990, U.S. bonds have averaged returns of 2.5% in positive-return quarters; global bonds offered 2.3% in the same quarters, capturing 92% of the upside of U.S. bonds. That’s because global government bonds tend to move together in widespread flights to quality.”
He continued, “In adverse bond markets, however, there has historically been a greater performance gap, with global bonds faring significantly better than U.S. bonds. While U.S. bonds declined 1.1% on average in down quarters, global bonds lost only 0.7%. That’s 62% of the downside of U.S. bonds — a significant advantage.”
Capital appreciation
Now the question is how to reposition your stock portfolio in anticipation of higher rates. I mentioned earlier the potential risk with dividend stocks. In fact research backs me up. Research indicates that in rising rate environments, investors would be wise to look at growth stocks. According to Lord Abbett, “Returns for different equity segments during seven periods between September 1993 and December 2013, when the yield on the 10-year Treasury note was rising significantly, shows that Growth stocks (as measured by the Russell 1000 Growth Index US:RLG ) led the way with a median return of 31.2%. At the other end of the spectrum, high-dividend stocks (represented by the Dow Jones Select Dividend Index) lagged behind, with a median return of just 6.6%.”
While this may be an indication of bad news for the dividend stock lovers out there, the question is why do growth stocks perform so well when rates rise? Tom O’Halloran, Lord Abbett Partner & Director of Multi Cap Growth explains the success of growth, “Their comparative advantage has improved because their costs have come down, the rapidly growing emerging markets now make up a larger share of their sales, and they’re in the midst of a productivity boom led by technology.”
I would add, as I mentioned above, that high dividend payers lag in rising rate time periods because their yields are less attractive.
The last thing you want is to be buying high. Remember the old investing axiom: Buy low and sell high. Make sure you are ready for the new higher rate reality. Review your portfolio to see if you may be overexposed to dividend stocks and if a transition to growth makes sense.
DISCLOSURE: JNJ, KMB, growth ETFs and global bonds are held in client portfolios.
