Investing in high dividend stocks may offer a way to get exposure to equity markets while also generating an income stream. However, not all dividend-paying stocks are created equal when it comes to being a source of income and/or lower volatility.
For stocks, it matters why rates rise
First, there could be any of several different reasons why rates might rise, as we discussed in a recent post. Some of these scenarios are better for investors than others. Dictated by simple arithmetic, prices of most bonds fall when interest rates rise, regardless of the reasons why. However, rising rates may affect some equities differently. First, consider why rates are rising to determine the answer, as the reasons for rising rates matter to equity investors. Rates may rise because:
- The economy is growing and there is more demand for credit. This is the best scenario for equity investors generally.
- Inflation is increasing toward, or perhaps even above, investors’ expectations and/or the Fed’s 2% target. This is less beneficial, as it means companies’ revenues and expenses might both be increasing. But this environment may also allow companies to increase their dividends.
- The Fed may continue to raise rates in advance of a projected increase in inflation, or perhaps a desire to head off speculation in the financial markets. This factor is more ambiguous, but a Fed that feels more comfortable with higher rates may inspire confidence on the part of investors.
Some dividend-paying sectors are better than others
Not all high dividend stocks are created equal, especially when it comes to their sensitivity to interest rate risk. One primary issue is that some stocks that are bought primarily for their dividend yields (think utilities and REITs, as but two examples) can also exhibit some correlation to bond markets. In other words, when interest rates rise, these equities that are viewed as bond substitutes can see their prices pressured along with bonds, whose prices fall when interest rates rise.
Better to invest in stocks that can do well in the types of economic conditions that happen to favor both economic growth and rising interest rates. Indeed, a growing economy is also often consistent with a rising rate environment.
As such, investors may consider dividend-paying stocks that have more of a correlation to equity markets than to bond markets; that is, they have some sensitivity to economic growth. These may include dividend stalwarts in sectors such as telecoms, energy, and financials, along with industrials and consumer stocks, among others.
- Shares in financials may even tend to benefit when interest rates rise, as higher rates make lending more profitable for banks or reduce the value of liabilities for insurance companies.
- Telecoms also have some correlation to economic growth, which may coincide with periods of rising interest rates, and some of these companies have higher dividend payout rates.
- Meanwhile, energy companies can benefit from rising oil prices, offering some protection to what might otherwise be bond-crushing inflation pressures.
- Industrial and consumer companies may be able to raise prices faster than their labor and other input costs in a growing economy, and pass along some of those profits to shareholders.
Upsides and downsides of high dividend paying stocks in a rising rate environment
A possible upside might be a potential hedge against unexpected inflation. Aside from TIPS and some floating rate fixed income instruments, most bonds usually offer no such protection for inflation. However, the stock of a company whose earnings may increase with inflation – thus possibly paying higher dividends over time – may offer one potential inflation hedge. Thus, dividend paying stocks may offer a useful complement to other yield-oriented instruments for an investor who is withdrawing income.
A downside could be the degree to which a given stock is bought primarily for its dividend. Perhaps paradoxically, the more investors favor a particular investment primarily for its yield the more vulnerable it can be to losses during a rising interest rate environment. Since bonds can be a suitable investment alternative, some of these sectors can be vulnerable to rising rates like bonds are.
Thus, certain sectors renowned for their yield, including REITs and utilities (not to mention preferred stocks), might have more sensitivities to rising rates. These sectors tend to have a bit more correlation to fixed income markets than other equity sectors.
That means that some dividend-heavy securities could see a price hit if interest rates rise, just like most bond prices would. Why would these stocks suffer along with bond prices during a rising rate environment? As bond yields rise, that siphons off funds from equity investments, if investors believe bonds now offer a sufficiently attractive yield at a perceived lower level of volatility.
As such, what is always paramount is that yield is only one consideration to an investment. When buying a stock, it should be of a company with sound fundamentals, one you might own regardless of its dividend. Thorough analysis includes myriad variables, and a high yield does not necessarily mitigate risk. Instead, it sometimes may merely change the types of risk to which you’re exposed. And of course, consider your own personal circumstances: what is right for you may be different than what’s right for your neighbor. That’s why your United Capital financial adviser is always available to help you find your own personal solution to your financial life management.
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