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.

Those companies are not likely to be the ones now paying 4 percent yields, and some might be paying a 1.5 percent yield or less. But "they have the dividend growth that is double-digit each year, and it doubles and triples over time," Taylor says. Among his top holdings is Johnson & Johnson, which earlier this year lifted its dividend payment 8 percent. The company, which has increased its dividend for 51 consecutive years, reported stronger-than-expected profit this week.

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Franklin Rising Dividends has managed average annual returns of 7.22 percent over the past five years, even after taking its 5.75 percent upfront sales charge into account, according to Franklin Templeton. Taylor says the fund screens first for companies that have raised dividends in eight of the past 10 years, then looks for strong cash positions and low debt. The fund then selects stocks that diversify its holdings by sector and relative value.

Buying higher-yielding dividend payers might work better if the economy remains weak. There is a risk that a strategy of targeting stocks with rising dividends might underperform a more yield-focused approach if interest rates return to the historic lows they were at in May, and the Fed keeps buying mortgage securities, Taylor concedes. Locking into higher yields of relatively high-quality stocks would make sense if the economy gets "weaker than the Fed says it is and tapering gets put on the back burner," he says. If rates drift downward, higher-yielding stocks with good credit quality would be the best option.

"The more likely scenario is that the Fed will be getting out of the bond-buying business and the recovery becomes more clear with yields normalizing," he adds. When that happens, companies with the capacity to increase dividends more quickly in an expanding economy will do better.

Avoid both extremes of high current yield and the promise of dividend hikes in the future. Equities strategist Josh Peters, editor of the Morningstar Dividend Investor newsletter, has created two model portfolios for Morningstar with one aiming for dividend growth and other for above-average yield. Both are up for the year with gains of 19 percent to 20 percent. Peters says he does not pick stocks whose yields are in the 1 percent range, even if they have been boosting dividends, or stocks with higher yields in the 8 percent-plus range.

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Whichever strategy you chose, dividend-paying stocks are likely to outperform in the years ahead, Peters says. In part, he says, that's because the stock-buying public, made up of aging baby boomers, is seeking out higher-yielding stocks, and companies will respond to that demand.

"We haven't seen a whole lot of damage to the equity-income sector and after the interest shock, they traded even higher, sharply outperforming fixed-income," he says.

So some equity-income funds that consistently outperform might be worth the fees they charge. But in an environment where dividend stocks are in demand, a low-cost strategy of buying solid dividend-paying stocks or index funds might work just as well. The dividend-paying stalwarts showed they can indeed gain even as rates jump, Peters says. "If this is what a rising interest rate is like, I say bring it on," he says.