In recent years, historically low interest rates have led many investors to seek income from dividend-paying stocks. This penchant for yield led to strong demand for dividend-paying stocks in general, and dividend stocks with higher payout ratios—those paying a higher percentage of earnings as dividends—in particular.
The willingness investors have shown to pay a premium for high absolute yield may have boosted the income from their portfolio, but as valuations rose on high yield stocks, so too did the risk of price losses.
With a recent sharp rebound in bond yields, the investment outlook for dividend-paying stocks appears to be more unpredictable and uncertain. If rates begin to rise, some dividend stocks may be hurt, while others are much better positioned. So investors may want to reconsider the type of dividend stocks they own, and look at actively managed mutual funds and separately managed accounts to manage the risks and opportunities in this part of the market.
As rates fell investors paid up for dividends
As bond interest rates fell to 50-year nominal lows in recent years, many investors looked beyond the bond market for income-producing investments. This caused an increase in the value of dividends on a stand-alone basis, apart from their role in equity valuations. The market increasingly took a bifurcated view on company earnings, treating distributed earnings (i.e., dividends) and undistributed earnings very differently. As the past few years have shown, the lower interest rates fell, the higher investors generally valued dividend payments (see chart).
As investors gravitated to dividend-paying stocks, this subset of stocks outperformed the broader U.S. equity market and provided lower volatility. Yield drove the performance, more than strong earnings or free cash flow.
As a case in point, the high-dividend-yielding utilities sector delivered 11% lower operating income1 and consistently negative free cash flow from mid-2014 to mid-2016. Still, utilities stocks returned 27% as a group over the period, outperforming the broader U.S. equity market by roughly 15 percentage points. Not surprisingly, it was an expansion of the price-to-earnings multiple of utility stocks, from 16.5 to 19, rather than earnings growth, that accounted for the majority of outperformance.
Higher-dividend-paying stocks also exhibited lower volatility during the secular decline in bond yields. During the five-year period ending in 2015, high-dividend payers exhibited a 10.0 standard deviation of returns (a measure of risk), compared to 14.3 for non-dividend payers.2
Interest rates can matter for dividend stock returns
Historically, the fundamental business characteristics of companies, including their cash flow, return on assets, and earnings growth, have had the most significant influence on stock prices over the long term, while macro-oriented factors, such as interest rate movements, have mattered less.
Since the advent of the low-rate environment post the financial crisis, the correlation between dividend-paying utilities stocks and U.S. Treasuries has become more tightly bound. What was once an unstable and unpredictable correlation became stable and very positive over the past five years, representing the impact of falling rates on stock performance (see chart).
High-dividend-paying sectors have struggled when rates have risen
During this recent period of higher return correlations with interest rates, the performance of equity sectors with the highest dividend yields responded most significantly to the direction of interest rates. To illustrate just how powerful interest rate movements were vis a vis equity sector returns, we analyzed sector performance in tandem with interest rate changes over the past four years. The results revealed some patterns that could shape performance during rate changes in the future.
During this period the most bond-like, high-dividend-yielding sectors, namely utilities and consumer staples, outperformed the broader stock market by between 0.44 percentage points and 0.80 percentage points per week on average when rates declined. Conversely, when rates increased, these sectors gave back an almost commensurate 0.50 to 1.00 percentage point of average relative performance per week (see chart). Meanwhile, the financials sector meaningfully underperformed when rates declined, and vice versa.
The results of this analysis do not suggest that individual investors should pay attention to weekly fluctuations in interest rates or stock valuations. Rather, this analysis may foreshadow what will come to pass over longer periods, as interest rates eventually rise from their low levels of the past several years.
Stocks with lower payout ratios have performed better amid rising rates
During this period of higher correlations in the past four years, not all dividend-paying stocks moved in tandem with the direction of interest rates. The most pronounced performance came from the top 20% of stocks by yield, which outperformed when rates fell, and vice versa.
Meanwhile, contrary to popular belief, there are pockets within the dividend-paying equity universe that outperformed when rates rose. The subset of dividend payers that tend to hold up (and even outperform) the market during periods of rising rates are the middle-to-lower-yielding segments of the universe. Not surprisingly, this subset encompasses the companies with payout ratios below approximately 40%—meaning those companies that have some room to grow their dividend and are valued for more fundamental factors beyond just their current income stream.
As rates rise, where should investors source income in the U.S. equity market?
Historically, dividend-paying stocks have provided a compelling return over the long term, with less risk than non-dividend payers (see chart).
However, dividend-yielding stocks form a heterogeneous group that defies easy generalizations. In a steadily declining interest rate environment, the penalty for not being discriminating in one’s choice of securities to own was muted—most stocks with higher-dividend yields than the broader equity market outperformed.
However, that tailwind of a low and declining interest rate environment is likely to be less favorable going forward, and may in fact become a headwind. The penalties for overpaying for a certain level of dividend income may be amplified going forward, as might be the rewards for thinking forward about which companies can sustain and grow their dividends. The "rising tide lifting all boats" backdrop that existed during the past several years—may no longer exist in the coming years.
As the environment gradually retreats from a zero-bound interest rate environment, fundamental factors are likely to matter more. Can a company grow dividends to maintain a positive yield spread relative to potentially rising bond yields? Does the business model behind a dividend payer benefit from or get hurt by rising inflation?
An actively managed approach that can nimbly move in and out of sectors and securities to source dividend yield from the best-positioned companies is likely to matter more now than it has during the past several years. The corners of the market that appear relatively attractive amid this potentially adjusted backdrop include the financial and industrials sectors and stocks with lower payout ratios at or below 40%. However, it’s also important to keep in mind that these risks/rewards can shift rapidly, and there is no substitute for a thoughtful, forward-looking approach to constructing dividend-oriented equity portfolios.
- James Morrow and Naveed Rahman are part of the equity income team at Fidelity, which manages Fidelity Equity Income Strategy, and the Fidelity Equity-Income Fund (FEQIX). Other income oriented products designed or managed by the same broader team include Fidelity Growth & Income (FGRIX), Fidelity Dividend Growth (FDGFX) and Fidelity Equity Dividend Income Fund (FEQTX) and the Fidelity Dividend ETF for Rising Rates (FDRR) or the Fidelity Core Dividend ETF (FDVV).
- Find other mutual funds, ETFs, and individual stocks.
The Russell 1000 Index measures the performance of the largest 1000 U.S. companies in the U.S. equity market.
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