Rising Interest Rates A Headwind For Dividend Paying Stocks

Since July 2016 the yield on the 10-year US Treasury Note has increased from 1.32% to nearly 3% today. This doubling of longer term interest rates is creating a headwind for dividend paying stocks resulting in their underperformance versus their non-dividend paying counterparts as well as the broader S&P 500 Index.

The maroon line in the below chart represents the total return for the S&P 500 Index divided by the total return for the iShares Select Dividend ETF (DVY), When the maroon line is moving higher, the S&P 500 Index is outperforming the iShares Dividend ETF. Clearly the broader S&P 500 Index has been outperforming the dividend payers since July 2016. The blue line on the chart represents the yield on the 10-year U.S. Treasury Note and it is not a coincidence that the dividend payers are underperforming just as the 10-year Treasury yield began to rise in July of 2016.

Although rising interest rates place downward pressure on returns for the dividend paying stocks, the dividend payers can still achieve returns that are better than bonds. However, with higher returns comes potentially higher volatility, i.e., stocks are not bonds and the payers are likely to decline in a falling equity market environment.

Looking at a two month time frame, the below table details the average return of the payers versus non-payers in the S&P 500 Index. During this short period, the payers are underperforming the non-payers by more than 400 basis points and underperforming for all time periods shown in the table. However, on a cap weighted basis, the S&P 500 Index is outperforming the average return of both payers and non-payers over the last 12-months in part due to mega cap stock outperformance.

And lastly, the underperformance of the dividend payers is showing up in the performance of the Dogs of the Dow Strategy. As noted in a few earlier posts, the Dogs of the Dow strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds them for the entire next year. The popularity of the strategy is its singular focus on dividend yield.

As the below table shows, the year to date return of this year's Dow Dogs is significantly underperforming the Dow Jones Industrial Average Index. Not shown below is the YTD return for the S&P 500 Index, but the S&P 500 Index has a small positive return through last Friday's close and the Dow Dogs are underperforming the broader market as well.

Last week the new Fed chairman, Jerome Powell, provided the semiannual testimony on monetary policy. One conclusion taken from his remarks is the Fed likely will be more hawkish going forward, all else being equal. This potential for a continued move higher in interest rates will have a negative impact on the performance of dividend paying stocks as the year unfolds.