Dec. 13 (Bloomberg) -- The prospect of rising interest rates in 2014 is sending shares of high-dividend-yielding companies lower as fixed-income assets become more attractive to investors.
The Dow Jones U.S. Select Dividend Index has lagged behind the Standard & Poor’s 500 Total Return Index by 4.6 percentage points on a total-return basis since April 30. During the same period, the yield on 10-year U.S. Treasuries has risen to 2.88 percent from 1.67 percent. The dividend group fell to its lowest level in more than a year Dec. 11 relative to the broader gauge.
The dividend index -- made up of 100 companies including cigarette maker Lorillard Inc. and Chevron Corp. -- has weakened since the Federal Reserve began bracing investors for a phase-out of its unprecedented monetary stimulus. At the conclusion of a two-day meeting May 1, the Federal Open Market Committee said in a statement it was “prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”
Amid this environment, “stocks that have been hurt the most are those that benefited a lot from lower interest rates,” said Brad Kinkelaar, executive vice president and portfolio manager at Pacific Investment Management Co. in Newport Beach, California, which oversees $1.97 trillion in assets.
Shares of telecommunication, utility and real-estate investment-trust companies have been hardest hit, said Kinkelaar, who manages two dividend strategy funds. “If rates continue to rise through 2014, albeit gradually, these stocks should continue to underperform the market.”
The yield on 10-year Treasuries will increase to 3.37 percent by the end of 2014, according to the median forecast of economists surveyed by Bloomberg.
With tapering very likely in 2014, a “key-risk scenario” is that the yield could climb to a “fair value” of 3.7 percent by the end of next year, said Benjamin Brodsky, global head of fixed-income asset allocation in London at BlackRock Inc. “This would be a significant surprise to the market, adding volatility to the landscape not only in Treasuries but also in other asset classes.”
For about two years prior to mid-2013, large-cap dividend-paying stocks were attractive because interest rates remained low, said Rob Morgan, who oversees $1 billion as chief investment strategist in Exton, Pennsylvania, at Fulcrum Securities LLC. Now, with yields on 10-year Treasuries moving up since May -- and the prospect of more increases -- “that will definitely hurt this strategy.”
That’s partly because higher rates on fixed-income securities mean more competition for stocks, particularly those with dividend yields at a premium to the rest of the market, Morgan said.
Investors have become more aggressive about pulling money out of the dividend index, according to Jim Stellakis, founder and director of research at Greenwich, Connecticut-based research company Technical Alpha Inc. Amid a general downtrend for this group relative to the S&P 500 total-return index, its performance also has been marked by lower peaks and troughs, which shows “people are becoming more impatient and selling sooner.”
If the dividend index falls below a March 2012 trough, this will be the next indicator of further deterioration in investor sentiment, Stellakis said.
Poised to Rise
As the U.S. economy moves into later stages of the expansion that began in June 2009, investors need to be “more selective about the type of dividend-paying stocks” they purchase, said Eric Teal, who helps oversee $5 billion as the chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina. There’s a distinction between companies with high-dividend yields relative to the market and those whose payouts may be poised to increase, he said.
“We’re looking for stocks that have growing dividends and have leverage to an economic recovery, especially on a global basis,” Teal said, adding that industrial companies fit this criteria because they’ve expanded payouts in recent years. As a result, signs of strengthening in the U.S. could bode well for these types of equities, he said.
The Dow Jones dividend index has risen almost 25 percent on a total-return, absolute basis this year as U.S. employers have added an average of 188,550 jobs each month, the most since 2005, according to data from the Labor Department. Gross domestic product expanded at a 3.6 percent annualized rate in the third quarter, up from an initial estimate of 2.8 percent and the strongest since the first quarter of 2012, based on figures from the Commerce Department.
Against this backdrop, Kinkelaar still sees ample opportunity for selecting stocks with attractive dividends, particularly those that will benefit from worldwide economic growth, he said, adding that about half the companies in his funds are based outside the U.S.
For domestic businesses, the strategy continues to “largely avoid the most expensive parts of the market” -- including shares that have been hardest hit by the increase in interest rates, Kinkelaar said.
Toll-road companies in China, Brazil and Italy -- including Zhejiang Expressway Co. and Arteris SA -- fit this criteria, as do U.S. retailers such as Foot Locker Inc. and Kohl’s Corp., Kinkelaar said.
It’s inevitable the Fed will taper its $85 billion in monthly bond buying, though the timing and pace remain to be seen, Brodsky said. The central bank “will be losing one of its essential tools to control the long end of the market” amid signs the recovery is strengthening, he said.
The Fed probably will begin tapering at its Dec. 17-18 meeting rather than wait until January or March, according to 34 percent of economists in a Dec. 6 Bloomberg News survey, an increase from 17 percent in a Nov. 8 survey.
While an improvement in the job market has raised the odds of a change in the stimulus, any reduction should be modest to account for low inflation, James Bullard, president of the Federal Reserve Bank of St. Louis, said Dec. 9. “Should inflation not return toward target, the committee could pause tapering at subsequent meetings.”
Higher rates may encourage investors to swap equities for fixed-income securities, though a “significant move” isn’t imminent yet, Morgan said. When yields on 10-year Treasuries approach 4 percent, this will be a trigger for asset-allocation models, Teal added. “We’re in a transition period as equity investors adjust to a rising-rate environment,” Teal said.
Still, the underperformance of many high-dividend-paying stocks in the past eight months shows a sentiment shift already is under way as some investors falsely assumed many of these stocks were “safe assets,” Kinkelaar said. Money managers with dividend-paying strategies flocked into “a fairly limited menu of attractive-yielding stocks in the U.S.,” which caused those share prices to increase significantly since the 18-month recession that began six years ago, he said.
“There was a scarcity effect that benefited some of these stocks and now the reverse is happening.”
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