Lesson From a Market Panic: Beware of 'Safe' Yields

Which dividend stocks are best for rising rates?

NEW YORK, NY - JULY 11: Traders work on the floor of the New York Stock Exchange at the end of teh trading day on July 11, 2013 in New York City. The Dow Jones Industrial Average closed at record high today, up 169.26 points to close at 15,460.92.
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Not all stocks are alike when it comes to payouts. That should come as no surprise to people who thought they were doing the right thing by buying "safe" dividend-paying stocks earlier this year, then got slammed as interest rates soared in May. The bond market plunge in May and June pushed rates higher and is an indication that today's highest-yielding stocks (which are more attractive to investors when bond rates are low) might not be the best investments if interest rates start rising again.

Fund manager Don Taylor of the Franklin Rising Dividends Fund says the most "bond-like" investments lost the most value and have been slowest to recover amid concerns that the Federal Reserve might let yields rise soon on signs that the economy is strengthening.

Interest rates appear to have settled at new, higher levels as the Fed calmed fears of an imminent end to its $1-trillion-a-year bond-buying program that has kept yields near all-time lows. But it did not remove the threat that rates will go up, as the economy remains in its recovery path.

[Read: Should Investors Fear a Market Pullback? 2 Views on Stocks .]

But the bond market volatility shows how quick big investors are to dump their bonds in anticipation that they will be able to replace them with higher-yielding securities. Income fund managers saw it as an early dress rehearsal for what might happen when the Fed finally decides the economy can handle unrestrained interest rates. Here's how a few sectors favored by equity investors seeking dividend yield fared during this particular bump in the bond market.

Utility stocks experienced deeper losses than most stock sectors. This is the stock sector whose market value is most dependent on current dividend yields. The market re-priced utility stocks sharply lower as other investments offered higher yields. Based on the Utilities Select Sector SPDR ETF, that loss was more than 8 percent from May 21, when the stock market began to fall, through June 24, when it hit its low. The bond market began falling earlier, in the first week of May. Utility stocks do offer a bit of an inflation hedge because utilities can boost dividend payouts, although not as quickly as some other types of stocks. The utilities shares rose sharply this year as investors snapped up any dividend-paying stocks, gaining more than 20 percent at one point. But Taylor says these shares were slammed during the downturn, again because they are seen as "bond-like."

Real estate investment trusts were hit even harder. That was one of the biggest surprises in the reversal. Some investors bought REITs based on a belief that an improving economy would help commercial real estate rentals that make up many of these investments. But REITs also are buyers of fixed-income mortgage securities. That, and the fear of rising costs for funding their income properties, put REITs in a real downturn. The iShares Dow Jones U.S. Real Estate ETF dropped more than 15 percent during the May-June period. It has since recovered one-third of its loss.

Other sectors performed better and recovered more quickly. Instead of looking for the best yield available, Franklin's Taylor seeks companies "that can grow their dividends over time," which means a mix of "more economically sensitive companies," he says, with health care, retail and capital goods more likely to provide bigger increases. His fund lost about 4 percent during May-June period but moved on to new highs and is now up 18 percent so far this year.

Taylor says investors can pursue an income strategy that avoids both REITs and utilities. There are none in the top 10 holdings his fund lists. The fund's total return is enhanced by rising stock prices for companies earning enough to boost dividends, he adds.

When the Fed boosts rates, the market is likely to look for companies that can lift payouts. "At some point, the Fed will stop buying mortgage securities as it does now," Taylor says. When that happens, interest rates will likely rise to more historic levels of about 4 percent for government bonds, compared with 2.5 percent now and less than 2 percent in May. Fixed-income investments will again lose principle value, and "bond-like" dividend stocks will as well. "You need to find the companies that can grow dividends substantially over time," Taylor says.