Rising interest rates are a sign of a strengthening economy, but they can spell trouble for investors.
Shane Eighme, financial advisor and partner at Shane & Shane Financial in Dublin, Ohio, says rising rates affect investors in two ways, by dragging down bond prices, which means lower yields for bond investors, and by indicating volatility.
“Rising interest rates signal volatility in the market, which makes it hard for investors to hold their position,” he says.
Investing in exchange-traded funds that offer high dividend yields and low volatility may be just what your portfolio needs as rates rise. These ETFs generate income from stocks, with potentially less risk than other mutual funds or individual stocks.
[See: 9 Dividend ETFs for Reliable Retirement Income.]
“Rising rates aren’t necessarily a bad thing for investors, depending on the reason why rates are rising,” says Daniel Kern, chief investment officer for TFC Financial Management in Boston. If rates are rising gradually in response to a strong economy, high-dividend ETFs may be a good investment option, he says. In many cases, these investments “offer higher yields than most bonds today, so the appeal is understandable.”
Although high-yield, low-volatility ETFs can help stabilize an income-producing portfolio as rates climb, these funds aren’t created equal. Here’s how to evaluate them before buying in.
Look at the big picture. Dividend-producing investments can mirror movements in the bond market, says Gene Balas, vice president of investment management at United Capital in Irving, Texas. When rates rise, stocks viewed as bond substitutes can see their prices pressured in the same way as bonds. He says investors should look for funds in sectors that do well when the economy favors both growth and rising rates. That includes dividend stalwarts like energy, financials and telecom.
ETFs that are overweighted in utilities or staples, on the other hand, may not yield the best results when rates rise, says Sean O’Hara, president of Pacer ETF Distributors, based in Paoli, Pennsylvania. He says dividend-paying ETFs that focus on free cash flow yield may be a better choice.
“Companies that have free cash flow can be better positioned to continue, and even raise, their dividends,” O’Hara says. He cites the Pacer Global Cash Cows Dividend ETF ( GCOW) as an example. The fund currently offers a dividend of about 4 percent, supported by free cash flow, and it’s underweighted in traditional sectors — like utilities and staples — that other dividend ETFs may overweight. O’Hara says that the higher interest rates go, the more important it becomes to understand what’s driving yields in high-dividend ETFs.
Investors should also think about a sector or company’s long-term dividend growth potential, says Christian Magoon, CEO of Wheaton, Illinois-based Amplify ETFs. If you’re hedging your bets against rising rates, you should choose funds that include companies with a history of increasing dividend payouts and the ability to continue doing so even as rates rise.
[See: 10 Dividend Stocks Boasting 100 Years of Payouts.]
“Companies that can grow their dividends will be more appealing because they can keep up with rising inflation and rising interest rates,” Magoon says. For instance, tech companies that pay dividends look promising because they’re positioned to increase their dividends long-term. Having a mix of dividend ETFs that feature established companies and newer ones offers investors the best of both worlds.
At the same time, you may want to steer clear of high-dividend ETFs featuring companies that have hit their individual dividend ceiling. When rates rise, there’s no room for those dividends to grow, Magoon says.
Balance out the risks. High-yield, low-volatility ETFs can mitigate risk in your portfolio, but they don’t eliminate it entirely. Eighme says these investments are like having your cake and eating it, too. You get a higher yield with less volatility, but there’s a catch. “Any time a company is high yield, that means their default risk is high,” he says. When that company issues bonds, they have to offer a greater interest rate to get investors to buy their debt.
That’s not the only risk either. Eighme says investors must also consider interest rate risk and how bond prices might be affected if interest rates continue rising. Liquidity risk is another concern. The upside is that high-yield, low-volatility ETFs tend to move slower than the market. That benefits investors because “it gives them a better chance to get out or stay in without moving too fast.”
Diversification can help counter these risks. The more broadly diversified a dividend ETF is, the better. This is why investing in sectors that benefit from economic growth and higher rates is so important. And don’t discount sectors like real estate, Kern says, as it can offer both higher dividends and greater insulation against market fluctuations and inflation.
Account for Uncle Sam. Although yield is important to keep in mind so are taxes. Dividends are taxed as ordinary income and not at the potentially lower long-term capital gains tax rates. If you’re still in your working years and don’t need dividend income right away, that may not be a concern if you’re reinvesting dividends as you earn them. Tax considerations take on new importance, however, once you retire and begin drawing on dividend investments for income.
Colin Exelby, president and founder of Celestial Wealth Management in Towson, Maryland, says dividends are inherently tax-inefficient, something investors often overlook. He says a dividend-based investment strategy may be better suited for retirement accounts versus a taxable brokerage account.
“When taxes are paid on dividends, whether through the sale of shares or out of pocket, those are opportunity costs lost,” Exelby says.
[See: 7 Ways to Tell If a Stock Is a Good Price.]
He says that potentially the greatest benefit of using dividend ETFs isn’t the actual dividends paid but their intrinsic value. Accumulating stocks in companies that trade for less than they’re worth may do more for your portfolio than the yield itself. And, “if you can acquire value with less taxable dividend yield, all the better.”
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The Payoff From High-Dividend ETFs originally appeared on usnews.com
