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.
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.
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.
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.
[See: Mutual Fund Scorecard: How 6 Famous Stock Pickers Stack Up.]
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.