Dividend stocks are in a slump because of rising interest rates and bond yields. But here’s the shocking news: The stocks are still expensive.
That’s the conclusion from strategists at Bank of America Merrill Lynch. And if they’re right, dividend stocks may continue to struggle as central banks raise rates, forcing income-loving investors to make a difficult decision: Whether to void big dividend yields and embrace dividend growth instead.
Financial markets are expecting the U.S. Federal Reserve to raise its key rate three more times this year in response to low unemployment and signs of inflationary pressures. The Bank of Canada is also on track for at least one additional rate hike this year.
The tighter monetary conditions have been weighing on bonds for most of the past year. As prices have fallen, the yield on the 10-year U.S. Treasury bond has risen above 3 per cent, from just over 2 per cent in September.
Since dividend stocks now have some competition from fixed income – arguably for the first time since the financial crisis a decade ago – stock prices have been declining. As a result, it is now easy to find telecom stocks and utilities with yields of 5 per cent or more.
These stocks are beckoning to anyone who likes the idea of being paid 5 per cent for sitting on a relatively safe stock with predictable profits.
But the strategists at Bank of America Merrill Lynch argue that this is not a good idea. They point out that so-called bond proxy stocks – notable for their high yields and slow-growing payouts – are pricey relative to dividend growth stocks, which have better growth profiles and tend to perform better in a rising-rate environment.
They compared the valuations for the two groups of stocks within the S&P 500, looking at relative price-to-earnings ratios since 1990. Over the past five years, high-yield stocks have traded at a premium of 5 per cent to 10 per cent more than dividend growth stocks, a trend that made sense when interest rates were stuck at ultralow levels but not in today’s monetary environment.
“We believe bond proxies are at risk in a rising rate regime,” the strategists said in a note.
They added: “Dividend growth stocks – which are more cyclical and can raise payouts as interest rates rise – have historically been uncorrelated with rates and look cheap versus history relative to their high dividend-yielding counterparts today.”
The strategists didn’t provide much detail. Nor did they get into Canadian stocks. However, a report earlier this year from S&P Dow Jones Indices uses U.S. stocks to explain why the two dividend strategies may respond differently to rising rates in any country.
Companies within the S&P High Dividend Aristocrats Index, 112 companies that have raised their dividends every year for at least 20 years, have lower debt, higher return-on-equity and stronger profit growth over the past three years than the 80 companies in the S&P 500 High Dividend Index – even though the aristocrats index has a lower dividend yield.
Canadian aristocrats and high-dividend stocks should have similar differences.
The S&P authors, Tianyin Cheng and Vinit Srivastava, said: “An allocation to companies that have sustainable and growing dividends may provide exposure to high-quality stocks and greater income over time, therefore buffering against market volatility and addressing the risk of rising rates to some extent.”
How can we apply these ideas?
If the economy continues to expand and central banks raise rates as expected, then investors should avoid the temptation of reaching for yield. Yes, you’ll get a big dividend, but share prices will lag.
Instead, consider investing in aristocrats, which is easily done with exchange-traded funds. The SPDR S&P Dividend ETF (full disclosure: I own units in this fund) tracks U.S. stocks. In Canada, the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF tracks stocks that have raised their dividends every year for at least five years.
Both ETFs are down from highs earlier this year. That’s because investors are still after yield, and ignoring growth.