December 2, 2021

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Dividend Investors Shouldn’t Panic Over Higher Interest Rates

Although bond yields retreated a bit this past week, they have moved up sharply since summer—a move that could spook dividend investors.

The reason: Higher bond yields pose more competition to dividend stocks, threatening valuations if investors turn to income-paying alternatives.

“Income-oriented investors—actually, all investors—need to be cognizant of the potential impact of rising rates on valuations and position accordingly,” says Mark Freeman, chief investment officer at Socorro Asset Management.

The 10-year U.S. Treasury note’s yield was around 1.63% on Oct. 25, compared with some 1.2% in early August, though well below where rates have settled in the past. The 10-year fell to 1.5% and change later this past week.

But strategists say that higher yields aren’t always detrimental to dividend stocks. “If bond yields are moving up in anticipation that the economy is going to improve, that’s still positive,” says Keith Lerner, co-chief investment officer at Truist Advisory Services. He adds that stocks generally can withstand a gradual rise in rates, as opposed to a spike.

Lerner says there have been 15 times since the 1950s when the 10-year Treasury’s yield rose at least 1.5 percentage points off its low. The S&P 500 had an average annualized return of 12% during those rising-rate stretches, he adds.

Lerner attributes the recent uptick in bond yields in part to concerns about higher inflation. In August, the personal-consumption-expenditures price index, which excludes food and energy, rose 3.6% from a year ago, according to the Dallas Fed, well above the 2% average the Federal Reserve is targeting over time.

Bond prices and yields move in opposite directions. Inflation is a big worry for bond investors, in part because it can erode fixed coupons.

Nevertheless, says Erin Browne, a portfolio manager who focuses on asset-allocation strategies at Pimco, “The absolute level right now of yields is still quite low and quite supportive for stocks.”

Still, Browne is keeping close tabs on interest rates. As a proxy for stock yields, Browne points to the


SPDR S&P Dividend

exchange-traded fund (ticker: SDY), which recently yielded 2.75%. That ETF seeks to track the performance of the


S&P High Yield Dividend Aristocrats Index,

which screens for companies that have increased their dividends for at least 20 straight years. Recent top holdings include energy giant


Chevron
(CVX) and drugmaker


AbbVie
(ABBV).

The spread between the ETF’s yield and the 10-year Treasury note has narrowed recently.

“If you were to see that compress further, and particularly if you were to see the dividend yield go below that of the 10-year Treasury, that would augur poorly for income-oriented equities,” says Browne.

The S&P 500 was recently yielding around 1.3%, well below the 10-year Treasury note. But yields vary widely across the S&P 500’s 11 sectors, with energy recently at around 3.8%, utilities at 3.1%, and consumer staples at 2.6%.

The $5.1 billion


JPMorgan Global Allocation

fund (GAOAX) recently had about 68% of its holdings in stocks, up from 65% at the end of September. The fund managers continue to favor stocks over bonds.

“Not only do you get the high dividend but you get the total return,” says one of the fund’s managers, Phil Camporeale, contrasting dividend-paying stocks with bonds. “That’s the fundamental difference between equity income and fixed income, especially credit, where spreads look extremely tight right now.”

Camporeale and his colleagues expect U.S. real gross-domestic-product growth will be around 4% in 2022 and that inflation will be between 2% and 2.5%. That will allow the Fed “to hold off on liftoff for at least a year” from now, says Camporeale, who doesn’t expect the first rate increase until December of 2022 at the earliest.

“If you have core inflation dropping from 3.6% to 2%-2.5% next year, that allows rates to continue to be a tailwind for taking risk rather than a headwind for taking risk,” he says.

His team’s belief that inflation will diminish hinges in part on the argument that the inflationary effects of reopening after the pandemic will subside. “You can’t reopen the economy twice,” he says.

Some portfolio managers warn of another concern. Even though rising bond yields might not pose an immediate threat to dividend stocks, investors should think about their stock allocations, especially if higher inflation persists.

“What’s really important is that the economic growth backdrop could be changing,” says Richard Bernstein, CEO of asset manager Richard Bernstein Advisors and previously a longtime Wall Street strategist. “We could have more inflation than people think. That requires a shift in an equity-income portfolio to emphasize stocks that are sensitive to nominal growth and that can raise their dividends to keep up with inflation.”

Nominal growth equals real GDP growth plus inflation.

Those more cyclical sectors include industrials, materials, and energy, notes Bernstein.

Truist’s Lerner says he’s more favorable toward cyclical sectors such as financials and energy. Energy firms can benefit from rising commodity prices and pass through those costs to customers, and banks’ net-interest margins are typically helped by higher rates.

“If the rates are moving up because of better economic growth or some inflation concerns, you want to be aligned with some sectors that would benefit from either,” Lerner says.

Write to Lawrence C. Strauss at [email protected]

https://www.barrons.com/articles/dividend-investors-higher-interest-rates-51635455611