Dividend investing still works in a rising rate environment

The Federal Reserve appears to be leaning toward an interest rate hike in December — and even if a hike doesn’t come in 2015, rates will rise eventually.

That is worrying to income investors, many of whom chased riskier, high-yielding investments to generate some income in a world where interest rates are near zero. People who held high-yield investments saw in August just how poorly these vehicles can behave when there’s a whiff of possibly higher interest rates. The market punished anyone holding interest-bearing investments, from dividend-paying stocks to real estate investment trusts.

But take heart, income investors: An increase in interest rates doesn’t mean dividend investing is over. Market experts say buyers need focus on quality instead of blindly buying the highest-yielding vehicle.

Watch out for bond substitutes. Richard Convy, president at AAFMAA Wealth Management & Trust in Reston, Virginia, which operates under the American Armed Forces Mutual Aid Association, says bond substitutes such as REITs and master limited partnerships tend to underperform during periods of rising interest rates. He expects that will be the case again.

Eric Wiegand, senior portfolio manager for Private Client Reserve of U.S. Bank Wealth Management in New York, says these higher-yield stocks are really lower-quality bond substitutes that can fall harshly in a rising interest rate environment.

The year-to-date returns and 12-month returns in sectors such as energy, telecommunication services and utilities registered some of the worst returns on a total return basis in the Standard & Poor’s 500 index, Wiegand says.

Pat O’Hare, chief market analyst at Briefing.com, a Chicago-based research firm, says the specter of an interest rate hike is bringing uncertainty into the market and some competition to dividend-paying stocks. That’s also affecting these investments. If interest rates do rise, low-risk investments such as Treasury bonds become more attractive.

“You have some new competition you haven’t had before,” he says.

Taking it slow. The Fed may raise interest rates, but the consensus is that the central bank will do so gradually. “The Fed is going from a very, very stimulative policy to more of a neutralized policy. They’re a long way to stepping on the brakes,” Convy says.

Jay Jacobs, director of research at New York City-based Global X Research, says his research reviewing the performance and behavior of high-dividend stocks during rising rate regimes from 1960 to 2014 showed that “high-dividend stocks continued to outperform the market seven out of 10 times and by an average annualized 0.78 percent.”

He added that during the three times when high-dividend stocks underperformed the market, “interest rates increased unusually rapidly.”

Wiegand says whether people are interested in dividend investing or some other investing theme, they should have a broad focus. “It’s an error to focus on a single aspect of an investment as making it appropriate. … We think it’s very important to have a strategic asset allocation plan that aligns and is consistent with an individual’s risk tolerance or investment horizon,” he says.

Josh Peters, editor for Morningstar’s DividendInvestor newsletter, also advocates a broad focus for investors.

“Whether you’ve gotten into dividend-paying stocks or are thinking about it now, that’s got to be a decision exclusively about you as an investor, not where the yield is, or the fact that interest rates are really low. Even though people do move money from bonds to dividend-paying stocks and back again, that really isn’t smart,” he says.

Since the Fed isn’t likely to embark on a cycle of tightening interest rates, dividend-paying stocks can still play a part in an investor’s portfolio, but it’s important to be selective, market experts say.

“One advantage, a huge advantage with dividend-paying stocks, is the income provides you with a consistently positive source of return,” Peters says. “Dividend-paying stocks had a terrible August if you look at the stock prices, perhaps, and it wasn’t a good month for the higher-yielding stocks, but dividends as a whole have been going up.”

O’Hare says if income investors can deal with the risk of capital loss when stock prices fall, then there are still opportunities to buy dividend-buying stocks.

Be an aristocrat. Convy and O’Hare say income investors should look toward the so-called dividend aristocrats if they want to stay with this theme. Dividend aristocrats have increased their dividends for at least 25 consecutive years.

“Those are the types of things you want to drill down on at this point, particularly since economic growth forecasts aren’t all that terrific,” O’Hare says.

One example is Johnson & Johnson (ticker: JNJ). Its dividend yield is 2.9 percent. “You [can] collect that dividend for five years, and you’re OK with the potential of facing capital loss [if share prices fall],” he says, pointing out that the yield is nearly double that of the five-year Treasury note yield of 1.7 percent.

Wal-Mart Stores (WMT) is another example. Its dividend yield is 3.3 percent. “People say it’s suffering from increased competition and some of their own execution issues, but that’s known. You’ve had Wal-Mart come way off its highs … from my perspective, if you have a multiyear holding time horizon, there are some good income opportunities in Wal-Mart and good capital appreciation if you take advantage of the adage to buy low and sell high,” he says.

Convy says his firm holds the ProShares S&P 500 Aristocrats exchange-traded fund (NOBL). It’s an equal-weighted fund and only holds stocks of companies with a history of increasing dividend payments each year. It has a 1.89 percent 12-month yield.

That’s a key criterion when researching dividend-paying stocks, O’Hare says.

“You’re better off targeting companies with very strong business models that have stood the test of time through all economic cycles and have the financial wherewithal to pay a dividend and increase dividends year after year,” O’Hare says.

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Dividend Investing Still Works in a Rising Rate Environment originally appeared on usnews.com

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