Download dividend stock investments in a rising interest rate environment

Tailored Portfolios | Disciplined Investment Process
2015
DIVIDEND STOCK
INVESTMENTS IN A
RISING INTEREST
RATE ENVIRONMENT
• Dividend-focused strategies deserve special focus from
long-term investors.
• Not all dividend stocks will perform in the same manner
when rates begin to rise.
• When a central bank makes its first increase of interest rates,
this generally signals a fast growing economy.
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Dividend Stock Investments in a Rising Interest Rate Environment
The Historic Relationship between Dividends and Returns
When long-term investors consider returns, many different metrics and questions come to
mind: What is the company’s operating margin? Does the company generate enough cash flow
to support its business model? What are the long-term prospects of the company’s business
model? While these questions are important, the aspect of total return that does not always
receive enough attention is the company’s dividend and how it contributes to return. Over the
last 75 years, dividends account for 44% of the total return of S&P 500 companies.1 While
there are many investing strategies, dividend-focused strategies deserve special focus from longterm investors.
Dividend Strategies in a Rising Rate Environment
When interest rates are at historical lows and rates are expected to rise in the near future,
a special question arises: How will rising rates impact a dividend-focused stock portfolio? Considering a generic stock in isolation, the rising cost of borrowing appears as a net negative.
However, rates generally rise because the economy is growing at a healthy pace. As a
consequence, a central bank uses monetary policies (like rising rates) that may help prevent the
economy from overheating. The other generic rising rate scenario occurs when central banks
raise rates due to inflation. This policy may signal a negative trend in the macro-economic
environment. So long as the market allows, corporations have the ability to pass inflation
through to consumers by raising
prices. However, purchasing dividend
While dividend paying stocks
stocks could in some respects be
considered an inflation hedge when
with characteristics similar to
companies pass on higher prices to
bonds – like utility stocks – may
consumers and reward investors with
spell trouble in a rising rate
higher dividends financed by these
environment, other dividend
elevated prices.
paying stocks may perform
better or exceptionally well in
the same scenario.
Given the complicated relationship
between rising rates, stock prices, and
dividends, the answer to the question
of how rates impact divided stocks
is not a simple matter. The impact
of rising rates will depend on many variables specific to a particular dividend paying stock. In
other words, not all dividend stocks will perform in the same manner when rates begin to rise.
1
Savage, Terry. Dividends, Buybacks Help Drive Stock Returns. Chicago Tribune. June 2, 2015.
Page 2 of 4
Dividend Stock Investments in a Rising Interest Rate Environment
Stocks Which Resemble Bonds Will Underperform
The type of dividend paying stocks that would be impacted negatively by rising interest rates
are those that most closely resemble bonds. A sector that illustrates this well is utilities. Utility
companies generally have high dividend yields and their revenue streams are less sensitive
to economic conditions. That means there is less risk to earnings during times of recession,
but the tradeoff is minimal growth potential during high economic growth periods. In other
words, a utility stock offers what amounts to a fixed income stream, with a minimal dividend
growth component and some upside or downside potential. These are some of the same
factors that cause a bond’s price to fall when rates rise. Thus, as rates begin to rise, stocks with
characteristics similar to bonds will begin to underperform.
This is a significant point for dividend investors. If yield is your primary deciding factor
for dividend investments, it could potentially lead you to a portfolio of assets that are highly
sensitive to interest rate movements. It also can concentrate your holdings into a specific
sector or industry, further increasing your investment risk due to lack of diversification. While
dividend paying stocks with characteristics similar to bonds – like utility stocks – may spell
trouble in a rising rate environment, other dividend paying stocks may perform better or
exceptionally well in the same scenario.
A Better Dividend Stock Option
The key to investing in dividend-paying stocks that perform better in such an environment is
to identify companies that have the potential to increase their payouts and have historically
increased dividends in the past. Stable, high quality companies with a long history of increasing
dividends on a regular basis fall into this category. Generally, these companies are considered
long-term core holdings. These stocks have historically outperformed during periods of rising
rates.
Another positive attribute to explore are companies that become more profitable during periods
of rising rates. In the financial sector, banks on average perform well, because they may be able
to earn more profits if interest rates on loans rise. Other historical outperformers include firms
which earn interest on money held temporarily for their clients. A payroll company serves as a
salient example of this type of company.
When a central bank makes its first increase of interest rates, this generally signals a fast
growing economy that should continue to expand and benefit those companies that are more
economically sensitive. Technology companies tend to fall into this category, because they tend
Page 3 of 4
The key to
investing in
dividendpaying stocks
that perform
better in
such an
environment
is to identify
companies
that have
the potential
to increase
their payouts
and have
historically
increased
dividends in
the past.
Dividend Stock Investments in a Rising Interest Rate Environment
Page 4 of 4
to be more economically sensitive while simultaneously carrying little debt. This characteristic
minimizes the cost drag related to rising borrowing costs. Consumer discretionary stocks also
generally perform well in this scenario as consumer demand for non-essentials increases during
periods of economic expansion. Dividend-paying companies in these industries and sectors can
increase their revenue and earnings while maintaining, and ultimately increasing, their dividend
payout rates. Unlike a bond, a dividend stock can simultaneously increase its payout rate and
increase its entity value. This overrides any drag associated with a rise in rates.
Not All Dividend Strategies Are Equal
An investment decision in dividend paying stocks during rising rates involves many individual
company variables along with an evaluation of the current market environment. From a
portfolio construction perspective, the challenge becomes avoiding sector and industry
concentration risk without sacrificing dividend yield. Overexposure to certain sectors and
equities which behave like certain fixed income instruments are common flaws for some
dividend strategies that have high yield targets. High yield dividend portfolios must be carefully
managed as interest rate movements can affect the risk profile of the portfolio and provide
performance results that do not match long-term expectations.
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November 2015