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As dividend-paying stocks fall out of favor, trading strategies could help

Advisers should resist the urge to shift their dividend-stock assets into bonds as interest rates rise and instead consider dividend swaps and futures, as well as option combinations

Jul 28, 2015 @ 12:01 am

By Eric Ervin

As the consensus coalesces around a Federal Reserve interest rate hike this fall, investors have begun to rotate out of stocks from traditional dividend-paying sectors, which had been popular through the prolonged period of ultra-low interest rates, as they clamor for yield.

Now, with the 10-Year Treasury note recently topping its highest yield since last November, the rotation out of dividend-paying stocks could accelerate and their total return will underperform the market. But as investors pull away from dividend stocks, where should they put that money?

The problem with dividend-paying stocks isn't that their payouts are expected to decline. On the contrary, Reality Shares Research has found that through periods of rising interest rates from 1972 through 2014, dividend growth was positive in 40 out of 43 years. In fact, the only time dividends declined during a rising-rate environment was in 2009 during the aftermath of the financial crisis and resulting stock-market correction.

Even though dividend payments have increased, investors in dividend-paying stocks have not fared well during periods of rising rates, suffering share price returns that substantially lag non-dividend paying stocks. In fact, in an analysis of market data from 1927 through 2013, Morningstar Inc. determined that stocks with the highest dividend yields had negative returns in periods of rising interest rates.

SOUND BASIS TO WITHDRAWAL?

Actual dividend payments may have even increased over that time, but as investors rotated out of the stocks in favor of rising bond yields, the share-price declines overwhelmed the dividend yield. So there appears to be a sound basis for investors to withdraw from dividend-paying stocks in the current market, and the evidence suggests the exodus has already begun.

The Wall Street Journal highlighted the trend in a May 31 article, U.S. Dividend Stocks Lose Luster, noting a reversal of the $48.4 billion of inflows into mutual funds and ETFs tracking utilities and REITs from 2010 through 2014. Citing Morningstar data, the Journal wrote that investors have pulled $3.5 billion from REITs and utilities funds so far this year, and the S&P Utilities index, MSCI US REIT index and Alerian MLP index have all posted negative returns for 2015 through May 28.

According to the article, “Utilities, real-estate investment trusts and master limited partnerships have been lifted since the financial crisis by a flood of money from portfolio managers and retirees starved for steady investment income amid low bond yields. But portfolio managers are pulling back from these shares in 2015, as the prospect of the first short-term interest-rate increase by the Federal Reserve in nine years makes high-dividend stocks less attractive. Investors reason that higher rates will boost the payout — and therefore the appeal — of more stable income-paying investments, like government and corporate debt.”

However, investors may be well-served to resist the reflexive urge to shift their dividend-stock assets into bonds. Although the market largely seems to agree that rates will begin to rise imminently, there is little consensus about the extent or duration of the rate-increase cycle. Thus, early buyers may find themselves on shaky ground. Research shows that dividend growth has outperformed the Barclays Aggregate bond index in periods of rising rates.

So what's the answer for advisers and their clients?

DIVIDENDS AS AN ASSET CLASS

While dividend growth has historically outperformed the total return of both dividend stocks and the bond markets in rising-rate environments, dividend-focused investing has traditionally focused on dividend-paying stocks, which carry stock-price risk. But over the past 15 years, dividends have emerged as an asset class in their own right. To gain exposure to dividend growth, advisers and investors can use tools such as dividend swaps and futures, as well as option combinations, which isolate dividend growth from the associated stock prices.

As these strategies grow in popularity, a growing number of major investment banks — including Societe Generale, BNP Paribas, Barclays and JPMorgan — now publish research on trading strategies to access dividends as an asset class.

According to a Societe Generale research report, “Dividend trading has grown exponentially over the past couple of years, propelled by the listing on exchanges of an increasing number of related futures contracts.… The investor base on dividends has markedly broadened from hitherto only trading desks and hedge funds to asset managers, pension funds and other more traditional market participants.”

While a rate increase is coming soon, the longer-term effect on the markets, stock prices and dividends remains to be seen. However, history shows dividend payments will likely rise, and capturing that growth can become an attractive strategy for advisers and their clients.

Eric Ervin is president and CEO of Reality Shares Inc.

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