Demographics and central bank-driven low interest rates have fuelled dramatic growth in dividend-oriented investments. These income-generating market sectors, particularly utilities and real estate investment trusts, have become "crowded trades," which are now at risk after a sharp selloff in global and Canadian bond markets.
Growth in utilities and real estate stocks has far outstripped the equity market as a whole. Since 2006 (maximum data available), the market capitalization of the S&P/TSX utilities index expanded by 240 per cent compares to the S&P/TSX composite's 137 per cent growth. The REIT subindex has seen even faster growth, 263 per cent, for the period.
The popularity of dividend investing is understandable as an aging population approaches or enters retirement and its requirement for steady income. Now, however, the same forces that made these investments successful are working in reverse, threatening future returns.
Rising bond yields are the biggest culprit. Despite all of the speculation about another Bank of Canada cut in rates, U.S. Treasury bonds have dragged the domestic five-year bond yield higher by almost 20 basis points this week.
The five-year government of Canada bond began the year yielding 60 basis points and is now hovering just below 100 basis points or 1 per cent. Selling in the bond market (for bonds, price and yield move in opposite directions) has only intensified in recent days.
The upper chart (below) shows that, while rates have not even reached the more elevated levels of September, 2014, the rising bond-yield trend is dangerous to investors in utilities stocks. Utility investments historically fall as bond yields rise and 2015 has been no exception. In non-dividend terms, the S&P/TSX utilities index has declined 1.8 per cent so far in 2015.
The trend is similar for REITs (lower chart), where returns are likely to decline as bond yields rise. The S&P/TSX REIT index has fallen 8.4 per cent since early February when fallout from the Bank of Canada's surprise interest-rate cut marked the bottom in yields for 2015.
It's not time to panic – 2015 returns are still acceptable when dividends are included – but, in the interests of risk management, it is probably time to reduce holdings of utilities, real estate and other interest rate-sensitive investments.
The U.S. Federal Reserve is widely expected to raise interest rates in late 2015. U.S. Treasury yields will undoubtedly rise in anticipation of this event – it might be happening already this week – and Canadian bond yields will follow no matter what the domestic economic data looks like (although possibly not as much).
More Canadians require income than ever before, but just because dividends are needed, doesn't mean the market is willing to provide them safely. Investors should expect the popular dividend-paying market sectors to underperform significantly for as long as bond yields climb.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.