Mortgage rates are rising, ditto for long-term Treasury yields. From historic low levels, interest rates probably have nowhere to go but up, especially when the Fed boosts short-term rates from near-zero.
Where should advisors direct clients in the search for investment success as yields rise? Money manager Lord Abbett suggested that investors should consider the stocks of dividend-growing companies. In a recent post on its website, Lord Abbett featured data from Ned Davis Research dating back to 1972, covering seven periods of escalating rates. In the three years after the initial Fed rate hike, dividend growers in the S&P 500 gained over 35%, on average, while dividend nonpayers gained less than 15%. Today, Lord Abbett investment strategist Steve Lipper pointed out, payout ratios are low while cash reserves are high, indicating dividend growth is likely.
However, dividend investors need to be selective. Rising interest rates are usually accompanied by economic growth, Scott Poore, director of investment solutions at Memphis-based Wunderlich Securities, told On Wall Street, and some dividend-paying stocks do not fare as well during periods of rising interest rates. Utility stocks, for example, are typically good investments during poor economic times but they often will underperform during better economic times.
Some dividend payers actually do well during periods of rising interest rates, according to Poore. Dividend-paying stocks that might benefit include those in the financial sector, he said, because higher rates usually indicate higher profit margins.
Lipper agreed that high-dividend stocks such as utilities might not do well in times of rising interest rates, because they tend to be rate-sensitive. Cyclical stocks also may not be ideal, if their highs and lows dampen prospects for dividend increases. The sweet spot, he said in an interview, could be investing in companies that are moderately economically-sensitive. Such companies probably will grow, as the economy expands. Historically, dividend-growers have strong balance sheets, so they may be able to keep raising their dividends.
Among clients, retirees might be good prospects for dividend-paying stocks, especially dividend growers. As Poore noted, retirees may need income from their investments and they often have a low tolerance for risk, so high-quality dividend stocks can be a good fit. Moreover, the 0% tax rate on qualified dividend income is now permanent, or at least as permanent as anything in the tax code; in 2013, taxpayers wholl owe that rate include married couples filing jointly with taxable income up to $72,500. Clients who are not in the 0% bracket probably will owe tax at 15%, which is still relatively low. The current tax status of qualified dividend income is attractive, Poore said. Dividend-paying stocks should be a portion of retirees overall asset allocation.
At least as important as taxation, Lipper added, is todays low-yield environment. Many retirees rely on income from their savings, but yields are down, he said. Yet they need more income to keep up with higher costs. If retirees need rising income from their portfolios, dividend-growing stocks can be the place to look.