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strategy lab

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

The spectre of rising interest rates hangs like a miasma over the Canadian economy. They're currently being warded off by an accommodative monetary policy from the Bank of Canada. But it is only a matter of time before inflation picks up and rates start to climb.

If they shoot up too fast, the real estate bubble might pop and take down a large part of the financial system with it. It's a thought that's causing some dividend investors to toss and turn at night.

Visions of financial Armageddon are easy to conjure up. But before getting carried away with them, it's helpful to take a step back and look to the past for guidance.

For instance, you might be surprised to learn that high-yield stocks fared relatively well when inflation ran amok and interest rates shot higher in the United States during the 1970s.

Professor Robert Shiller provides a little perspective on interest rates. He figures that 10-year U.S. government bond yields hit a low near 2 per cent in 1941 and then proceeded to march higher. By 1950, they clocked in at 2.3 per cent and more than doubled to 4.7 per cent by 1960. They motored on to 7.7 per cent in 1970, jumped to 10.4 per cent in 1980 and reached a peak of 15.3 per cent in 1982.

Over the past few decades, 10-year yields trended down and slipped to an all-time low of 1.5 per cent in 2012. They've bounced back a little bit since then and were spotted near 2.3 per cent this week.

While bond investors get headaches when yields rise, dividend investors face a more complicated situation because the businesses they own tend to grow over time. As a result, it is important to see what actually happened to dividend stocks when yields spiked in the United States.

Money manager and author James O'Shaughnessy breaks down the returns of high-yield stocks in the fourth edition of What Works on Wall Street. In one study, he focused on the returns of large U.S. stocks and tracked a portfolio containing the tenth of stocks with the highest yields.

The high-yielding stocks outperformed the market in the 1940s, 50s, 60s, 70s and 80s. They trailed slightly in the 1930s and fell behind the market to a greater extent in the 1990s – thanks to the Internet bubble, which burst just after the turn of the century. In other words, long-term dividend investors performed relatively well when interest rates climbed prior to 1980.

A more detailed look is provided by financial researcher Kenneth French, who tracks high-yield stocks over the long term. In one study, Prof. French followed a portfolio containing the 30 per cent of stocks with the highest yields, rebalanced annually, and weighted by market capitalization.

You can see the growth of the high-yield portfolio, along with that of the S&P 500, in the accompanying graph. It provides a window on the 20 years through to the end of 1982 and includes dividend reinvestment but excludes fees, taxes, and inflation.

I was somewhat surprised to see the high-yield portfolio beat the market in the 1960s when go-go growth stocks were all the rage. It also pulled ahead during the dark times of the 1970s when the market struggled.

Inflation was a real factor from 1963 to 1983 when the S&P 500 grew by an average of 2 per cent annually in inflation-adjusted terms. The high-yield portfolio climbed by a more robust real annual rate of 4.7 per cent over the same period.

History indicates that diversified dividend investors have little to fear from rising interest rates over the long term. Mind you, they aren't immune from short-term collapses along the way like the one seen in 1973-74, which can be quite distressing.