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Why Dividend Stocks Could Bounce Off the Mat in 2014

Wednesday's tapering announcement is a reason to give high-yielding sectors another look


While Federal Reserve tapering was the headline story for the markets in 2013, don’t expect a repeat in the year ahead. With the reduction in quantitative easing now officially set for January, investors largely know what to expect — meaning that tapering is set to move out of the headlines as we move through 2014. This removes a major headwind from stock market segments that have been under pressure through the second half of this year: utility stocks, REITs, MLPs and other dividend stocks.

Naturally, each of these groups has their own specific drivers of performance, as do the individual companies in each sector. Still, there’s little doubt that the concerns about rising bond yields have had a major impact on returns in the past year. After delivering strong relative performance in the 12 months prior to the surge in bond yields, each sector has lagged substantially since early May:

SECTOR ETF TICKER 4/30/12 – 4/30/13 5/1/13 – 12/18/13
Broader market SPDR S&P 500 ETF SPY 16.70% 13.02%
High-dividend stocks iShares Select Dividend ETF DVY 19.84% 8.25%
Utilities Utilities SPDR XLU 20.89% -7.34%
REITs Vanguard REIT ETF VNQ 19.20% -12.19%
MLPs Alerian MLP ETF AMLP 9.18% 0.47%

Although the bulk of this shortfall occurred in May and June, these groups have stayed sluggish through the second half of the year — and particularly in the past two months — due largely to uncertainty regarding Fed tapering. Now the Fed has fired its first shot on the taper, meaning we finally might have reached a buy-the-news moment at which higher-yielding investments again begin to attract investors’ interest.

What Tapering Means for Bonds … and Dividend Stocks

The crux of investors’ fear in the past two months was that the tapering would result in a severe selloff in the bond market in 2014, but this fails to account for the fact that bonds have already declined substantially: The 10-year yield closed Wednesday just short of 2.9% after trading as low as 1.63% on May 2.

This move, while large, doesn’t mean that yields will climb indefinitely as the taper plays out. In fact, the yields are capped to some extent by economic fundamentals.

Over time, the 19-year yield has traded at a level approximately equal to the rate of economic growth plus inflation. With economic growth expected to come in at about 2.5% in 2013, along with inflation of about 1%, this implies a target of about 3.5% in the 10-yield even if QE weren’t a factor at all. This indicates that bonds, at their current levels, have largely absorbed the worst of the tapering fears.

Further, the Fed made it clear that it doesn’t intend to raise short-term interest rates until 2015 at the earliest — meaning the short end of the curve remains pinned at current levels for at least another two years. As a result, a substantial increase in long-term bond yields would require the yield curve to reach unusually steep levels.

This indicates that dividend stocks are facing only limited competition from bonds at this stage. It’s true that Treasury yields are much higher than they were earlier in the year, meaning the “spread” between high-income equity investments relative to Treasuries has compressed somewhat during 2013. At the same time, however, the growing awareness that bonds aren’t on the cusp of a major bear market might well re-energize investors’ enthusiasm for yield-producing investments.

In addition, the near-unanimous consensus that the U.S. is on track for an environment of stronger growth in 2014 means the element of surprise is now slower-than-expected economic conditions. This indicates a positive risk-reward profile for bonds, and by extension, bond proxies.

These factors provide a positive underpinning for market segments that have been hit by tapering concerns in the second half of 2013. Based on the major ETFs, a few asset classes are offering very competitive yields at this point.

The Utilities SPDR (XLU) currently offers a 30-day SEC yield of 3.91%, while iShares Select Dividend (DVY) and Vanguard REIT Index ETF (VNQ) stand at 3.19% and 4.1%, respectively. The Alerian MLP ETF (AMLP) has a trailing distribution yield of 6.04%. (Keep in mind that figure doesn’t necessarily indicate what to expect in the next 12 months).

In comparison, the Vanguard Total Bond Market ETF (BND) still yields just 2.2%, even after a challenging 2013.

Bottom Line

While dividend stocks won’t be immune from an inevitable stock-market correction, they now appear to be increasingly safe from continued worries about Fed policy.

For those who have been shying away from income-oriented investments due to uncertainty about tapering, Wednesday’s news signals better days ahead in 2014.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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