Will rising interest rates spell the end for dividend strategies?

Tuesday, 10/30/2018

Income-oriented investors have long viewed dividend equities as an attractive source of yield. And rightly so, as dividends have accounted for over 40% of the total return of the S&P 500 – an index that has historically paid a relatively low dividend compared to other regions. We can see in the chart below that dividends contributed a significant portion to total returns.

Tuesday, 10/30/2018 - 11:32
Roberto Magnatantini Head of Global Equities
“Dividend stock indices are much better balanced than they were just two decades ago which has reduced their sensitivity to rising interest rates.”
Dividends have accounted
Dividends have accounted for 42% of the S&P 500’s total return since the 1940s
Morningstar. Data as of: January 2018

The importance of a regular dividend

Dividends tend to be steadier than earnings and they are of great importance to many investors who are looking for a stable income stream to help them meet their financial obligations. As the chart below shows, companies across the world have been very reluctant to cut their dividend payouts over the past 20 years, even at times when their earnings have fallen sharply.

Dividends have been much
Dividends have been much more stable than earnings over the past 20 years
SYZ Asset Management, Bloomberg, Thomson Datastream, UBS Quant and European Equity Strategy. Data as of: December 2016

But there’s more to dividend stocks than just yield; the need to pay a regular dividend has some important consequences on how a company is run: it encourages management discipline and tends to foster a prudent approach. When a portion of a firm’s earnings has to be distributed every year, the management is forced to prioritize the best projects and is discouraged from empire-building through acquisitions. The icing on the cake for investors is that dividends are paid in cash, which means dividends are not afflicted by creative accounting often seen for earnings or EPS.

And yet not all dividends are created equal. We would warn investors against companies paying unfunded dividends (those whose dividend yields are greater than their free cash flow yield over multiple years) and against companies whose balance sheets are loaded with excessive debt. In both cases, such firms have often taken advantage of very low interest rates to borrow cash to fund their payouts. This has been an especially common practice in the US, where share buy-backs have been extensively used to reinforce EPS growth. But in a rising-interest-rate environment, such a model could quickly become unsustainable. In the US, corporate leverage are already hitting historic highs (as the chart below shows), which can spell problems if these debt need to be refinanced at higher rates.

Corporate leverage
Corporate leverage in the US is at all-time highs
Thomson Reuters, Credit Suisse Research. Data as of: January 2017

Would rising rates derail the investment case for dividend stocks?

But let’s go back to yield. With trillions of global bonds still providing negative or barely positive yields, high-dividend stocks are attractive alternatives to bonds and other income-paying assets, as we can see in the following chart.

Equity dividends
Equity dividends compare favorably with fixed income yields
Bloomberg, Barclays, JPMorgan, Credit Suisse Research. Data as of: August 2018

The most obvious beneficiaries of investors’ hunt for yield over recent years have been the so-called "bond proxies" – stocks that provide high, but low growth dividends. These stocks tend to have a higher correlation with fixed income returns than the broader equity market. Telecom, real estate and utilities stocks make up most of this category. But with interest rates on the rise, the tide could well be turning, and bond proxies may be expected to suffer. Since the end of 2015, the US Federal Reserve has raised rates eight times to 2.25% for the target rate and is expected to hike again at their meeting in December 2018.

What sometimes goes unappreciated is the fact that industrials, healthcare, technology and consumer sector stocks have replaced traditional bond proxies as the main source of yield within the equity markets over recent years. As a result, dividend stock indices are much better balanced than they were just two decades ago which has reduced their sensitivity to rising interest rates. In the chart below, we see that dividend paying stocks can be found in all sectors and are no longer concentrated in a few.

Sector contribution
Sector contribution to total dividend paid for the MSCI World Dividend Index 2018 vs. 1998
SYZ Asset Management, FactSet. Data as of: August 2018

Companies in the financials, technology and industrials sectors are actually likely to benefit if interest rates rise, and together these firms make up a significantly greater proportion of dividend stock indices than the combined weight of the utilities, real estate and telecoms sectors. And as the chart below shows, in periods of rising rates, financials tend to outperform the most and utilities underperform the most. Given these divergent performance profile, it would be too simplistic to buy, or sell dividend strategies solely on expectations of changes in rates. An active manager can construct portfolios that achieve very different outcomes depending on stock selection and how he or she positions the portfolio for any specific rate scenario.

Therefore, rising rates is unlikely to derail dividend strategies unless they are built strictly around bond proxies.

Russell 1000 excess
Russell 1000 excess returns in periods of rising rates (2012–16)
Goldman Sachs. Data between January 1992 and July 2017

Seeking out the best opportunities

Where exactly can we expect to find the best dividend opportunities? Within financials the most obvious beneficiaries of higher rates would be banking stocks, as the steeper yield curves that result will enable banks to capture the higher differential between short-term borrowing rates and long-term lending rates. Industrials also tend to do well when rates go up, especially areas such as professional services and capital goods. Other cyclical areas with good potential for dividend growth can be found in the consumer discretionary and energy sectors. Meanwhile, the technology sector is home to some of the best earnings growth stories in the market, often backed by very strong balance sheets.

The latest market sell-off in the first half of October, while too recent to draw conclusions from, provided some interesting observations. Despite a sharp short-term rise in interest rates, utilities, telecoms and real estate substantially outperformed the broader market. Such a counterintuitive outcome was a good reminder of the complexity of the relationship between interest rates and equity returns. The defensive nature of these sectors was clearly more important in the eyes of investors than their supposed sensitivity to rates.