Outcomes for Income
Written by Sarah Abernathy, CFA, Director of Consulting Services
On the back of historically low bond rates that have fueled income-thirsty investors’ search for yield, equity income funds have enjoyed the nearly decade-long bull market as much as anyone. Demand for domestic equity income funds over the last seven years has coincided with generally declining longer term Treasury yields, round after round of Quantitative Easing, and loosening monetary policy at the Fed. As seen in the Annual Net Flows chart, demand was present even during periods when flows to total domestic equity funds were net negative, such as in 2010 through 2013 following the Great Recession. Bonds no longer delivered the income many investors needed, and evidence suggests at least some searched for yield within equities.
Market performance of the equity income asset class has also helped its growth. Over the ten years ending December 31, 2016, the MSCI USA IMI High Dividend Yield Index would have lagged the S&P 500 index on a simple price basis. However, factoring in the yield advantage of these stocks, they have instead outpaced the general equity market by a decent margin over this timeframe (see Cumulative Performance chart). Investments in dividend paying stocks have generated success over the last decade of falling bond yields, but what is in store for them as the Fed normalizes its balance sheet and regulates rates?
Research by MSCI has shown that, in a structurally low but rising interest rate environment (where the U.S. finds itself at present), higher yielding stocks have had a positive return in periods following rate increases. Likewise, J.P. Morgan shows the historical correlation between weekly S&P 500 price returns and 10-year Treasury yields tends to be positive, though diminishing, until an inflection point around 5% yield on the 10-Year. The positive correlation between bond rates and equity returns may be because rising rate regimes, particularly those that start during a period of structurally low rates, generally coincide with an improving or at least stable economic backdrop, which benefits stocks as a whole. Nevertheless, if we enter an environment where longer-term bond rates begin to rise in conjunction with increases to the Fed Funds rate, the high yield and relative volatility of equity income stocks will eventually become less attractive to those investors who may have piled into them when bond rates were trending down. This competition for capital may lead to a flight from these stocks and funds, putting downward pressure on their valuations.
An additional consideration is the distinction between the likely behaviors of high dividend stocks compared to dividend growth stocks. High dividend stocks are more often found in relatively highly levered sectors, such as Utilities, Consumer Discretionary and Materials. These sectors are more sensitive to rate hikes due to the subsequent increase in their borrowing costs, which cannot always be quickly passed on to consumers. The heat map to the right shows the performance of the various S&P 500 sectors during the last three periods of rising Fed Funds rates. From December 1993 to October 1995, the rate went from 3% to 5.75%; from December 1998 through March 2000, it went from 4.75% to 6%; from April 2004 through June 2006, it went from 1% to 5.25%. While no single sector was the consistent laggard over these timeframes, several of the more highly levered sectors were some of the poorest performers.
Conversely, dividend growth stocks are those stocks that have shown a history of increasing their dividend payout over time, and have avoided cuts to their dividend. These stocks have shown better resiliency across market cycles, including in periods of Fed tightening, while also maintaining yields that are generally greater than the broad market. Dividend growth is a function of earnings growth, so those stocks paying increasing dividends tend to show strong earnings growth trends and company fundamentals. Any number of stories can be produced showing the negative effects of a dividend cut on stock price - General Electric (GE) is a recent example. Dividend growth stocks have avoided this pitfall by prioritizing their dividends.
The High Dividend vs Dividend Growth chart shows the standard deviation and beta for the S&P 500 Dividend Aristocrats index, which focuses on consistent dividend growth, versus the FTSE High Dividend Yield index, which focuses on high dividends. The S&P Dividend Aristocrats index currently yields around 2.4%, while the FTSE High Dividend Yield index yields around 2.9%. Though measured over a short 10-year horizon given the inception date of the FTSE index, the dividend growth group has had less volatility and a lower beta than the high yield focused basket. Moreover, the S&P Dividend Aristocrats index outpaced the FTSE High Dividend Yield benchmark by over 200 basis points over this timeframe.
An environment of low inflation, sound corporate earnings, indications of measured rate increases from the Fed, and longer-term bond rates that are slow to incorporate changes to the Fed Funds rate make it unlikely that any dramatic effect from rate changes will be felt by dividend paying stocks immediately. However, at this point in the cycle, a better outcome for income portfolios may be secured by shifting the focus to quality of equity yield versus quantity.
1 How High-Dividend Stocks Fared When the Fed Tightened. Retrieved from https://www.msci.com/dividend-yield-factor
2 J.P. Morgan & Co. Guide to the Markets August 31, 2017. August 31, 2017. Available from J.P. Morgan Chase.
This blog post was written by Sarah Abernathy, CFA, Director of Consulting Services.