Dividend Investors: Don’t Worry About Rising Interest Rates

A version of this article previously appeared in the March 2022 issue of ETF MorningstarInvestor. Click here to download a free copy

There’s a lot to love about dividends. Receiving a regular check in the mail from businesses you own is a testament to their discipline, the health of their business, and their confidence in its future.

But the prices of companies with stable cash flows tend to be more sensitive to changes in interest rates than those with more volatile cash flows. Here, I will examine this relationship to understand if it is something investors should transpire.

Asset prices and interest rates fall near the schoolyard

Imagine interest rates and asset prices like playground buddies riding on either end of a seesaw in the schoolyard. When rates rise, asset prices tend to fall. When rates fall, asset prices rise. These ups and downs are more pronounced for long-term assets that produce predictable cash flows, such as long-term bonds.

Although their cash flows are not as stable or reliable as those of bonds, dividend-paying stocks tend to have a similar relationship with interest rates. Historically, the best performing stocks have underperformed those that do not pay dividends or have lower yields during periods of rising interest rates.

The opposite was true when rates fell: high-yielding stocks beat their less generous peers. Exhibit 1 illustrates this relationship. I looked at the monthly changes in the 10-year Treasury yield since May 1953. In defining the interest rate environments, I counted the 25% of the largest month-over-month percentage increases of the 10-year yields as “up” periods, the middle 50% as “stable” and the biggest 25% month-over-month declines as “down”. Using data from Kenneth French’s Data Library, I examined the performance of US equities in each environment, dividing the universe into dividend-payers and non-dividend-payers and sorting them into depending on the dividend yield.

Performance differences between stocks in the best performing and highest paying deciles are pronounced during periods of rising or falling rates. However, these spreads narrow significantly when rates are stable. And over the period as a whole, the performance gap between high-yielding and low-yielding stocks narrows further.

Exhibit 2 shows the results of an analysis I conducted on the returns of each stock portfolio. I measured each portfolio’s market sensitivity and monthly percentage changes in 10-year Treasury yields. The values ​​in the table indicate the sensitivity of each portfolio to variations in the variable in question. A positive value indicates that the two tend to move in the same direction, while a negative value indicates an inverse relationship.

Equity risk was least pronounced among stocks that exhibit characteristics closer to bonds: those that generate steady cash flows to their investors. These companies tend to be mature and their businesses tend to be less cyclical than most. These factors allow them to commit to paying – and in some cases increasing – their dividends over time. The market tends to punish companies that cut dividends, so companies with more volatile cash flows will be more conservative in their dividend policies.

While high yield stocks tend to have a low degree of sensitivity to market movements, they have a negative relationship with interest rate fluctuations. It is not a coincidence. Because they tend to have more stable cash flows, high yield stocks tend to have less growth when the economy is doing well to offset the negative impact of rising rates than yield stocks weaker. Conversely, they are higher when interest rates fall.

Sort by size

To better understand the relationship between dividend yields and interest rate sensitivity, we need to relate it to company fundamentals. Dividends are often a sign of maturity. As companies progress through their life cycle, their growth slows and reinvestment needs decrease, allowing them to distribute more cash. Using market capitalization as a proxy for maturity, this development is evident.

Exhibit 3 shows the results of an analysis I performed on SPDR S&P 500 ETF Trust (SPY), SPDR S&P MidCap 400 ETF Trust (MDY) and SPDR S&P 600 Small Cap ETF (SLY). I used these funds as a proxy for their respective strata of the market capitalization scale. Similar to the output shown in Exhibit 2, I measured their market sensitivities and the monthly percentage changes in the 10-year Treasury yield.

The relationships here are clear. Large caps tend to be less sensitive to market and interest rate changes than their smaller cap counterparts. This fits well with the general characteristics of large companies compared to their smaller counterparts. Specifically, they tend to be more mature and better capitalized and may have more diversified sources of income. These attributes lend themselves to less market sensitivity.

Sort by industry

While looking at interest rate sensitivity across market capitalization strata helps anchor this relationship in company fundamentals, the picture is still far from complete. Examining how this relationship varies across industries paints a more vivid picture. Exhibit 4 contains the results of a similar analysis I performed for 12 industrial portfolios from Kenneth French’s data library. Again, I looked at each portfolio’s market sensitivity and monthly percentage changes in the 10-year Treasury yield.

Industries that are generally considered to be defensive in nature – due to inelastic demand for their offerings and significant pricing power – tend to be negatively affected by changes in interest rates.

These include utilities and non-durable consumer goods. Companies operating in these sectors tend to produce more stable cash flows and therefore tend to suffer when rates rise and get a boost when they fall. More cyclical industries like energy and consumer durables exhibit the opposite relationship.

The demand for their output tends to fluctuate with economic output, as does their cash flow. As such, they tend to take advantage of rising rates (which tend to indicate a growing economy, inflation, or both) and are crippled when they fall (which often coincides with a slowdown in the economy). economy).

Now I’m going to take this a step further, applying that same lens to a select universe of dividend-focused exchange-traded funds that invest in US stocks that are also Morningstar Medalists with at least 10 years of track record. I ran these seven funds through the same analysis described above. In Table 5, they are ranked in descending order of their sensitivity to interest rates.

We find that Vanguard Dividend Appreciation ETF (VIG) has been the least sensitive to changes in interest rates and the most sensitive to movements in the broader market. The fund’s focus on dividend growth rather than dividend yield is a big reason why it has been less sensitive to interest rate movements than its peers.

At the bottom of the rankings we find VIG’s yield-focused counterpart, Vanguard High Dividend Yield ETF (VYM). The fund tracks the FTSE High Dividend Yield Index, which captures the most productive half of the universe of dividend-paying stocks in the US large- and mid-cap equity market. The index starts with the FTSE USA index and ranks its constituents according to their projected 12-month return. It then adds stocks in descending order until a 50% coverage of the market capitalization of the universe of dividend payers is achieved. This focus on dividend yield is why it is more sensitive to interest rate fluctuations than its counterparts.

don’t sweat

It can be helpful to understand how dividend-paying stocks and the funds that hold them are affected by fluctuating rates. But it is important not to confuse awareness and understanding with a call to action. Rates will go up and down, and no one knows when or by how much. Owning quality companies that regularly return money to shareholders is a solid strategy for all rate environments.

Disclosure: Morningstar, Inc. licenses indices to financial institutions as tracking indices for investable products, such as exchange-traded funds, sponsored by the financial institution. License fees for such use are paid by the sponsoring financial institution based primarily on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar Index. Morningstar, Inc. does not market, sell, or make any representation regarding the advisability of investing in any investable product that tracks a Morningstar Index.

Leslie M. Gill