Dividend stocks avoided a knee-jerk selloff last week after the Federal Reserve declined to raise a key interest rate, but rate pressure will continue to make it tough for any security that investors go to for yield.
Just remember: That hardly makes it time to ditch your dividend stocks.
You can be sure that rate hikes hurt dividend stocks. After all, dividend stocks, and anything else that competes with bonds for investor dollars, have trouble when the central bank enters a tightening cycle. Although bond prices fall amid higher rates, their yields rise, and that makes them more attractive to folks looking for income.
That’s why dividend stocks such as utilities are getting hammered in 2015 and why real estate investment trusts are underperforming the broader market.
Indeed, using exchange-trading funds as proxies shows that dividend stocks and REITs are having an especially tough time, as the market anticipates higher rates.
Look at utilities, which are income plays. The Utilities SPDR ETF (XLU) is off 10.6% year-to-date, against a 1.6% drop in the S&P 500.
As for REITs, the iShares U.S. Real Estate ETF (IYR) has lost 6%.
Click to EnlargeHad the Fed announced a rate hike last week, you can bet all those securities and more would have tumbled because the market usually overreacts to developments for which it should be prepared. Just check this Yahoo Finance chart to see how those ETFs dropped moments before the Fed news hit and then popped up in relief soon after.
But that still doesn’t change the facts on the ground. A rate hike is coming, and the market is forward-looking. Investors are always going to be cautious with dividend stocks against such expectations.
The Case Remains for Dividend Stocks
On the upside, any drop in the prices of dividend stocks not only makes their valuations more attractive, it boosts their yields for new money.
It’s also helpful to remember that dividends stocks don’t just give up in a rising-rate environment.
Dividend stocks can slide in the early part of a rate-hike cycle, but beyond that, their long-term total returns or dividend income levels do as well as any other rate-sensitive asset class.
The key here is “long-term total returns,” which is what dividend stocks are for, anyway. A sustained series of higher and higher dividend payments can give long-term investors truly impressive dividend yields on their cost bases.
A four-dollar-a-year dividend on a stock you bought for $100 gives you a dividend yield of 4%. Let’s say an extended period of rising dividends brings the annual payout up to $8. You’re now getting 8% on your original investment.
Add in some price appreciation, and quality dividend stocks can deliver superior risk-adjusted returns.
Ultimately, long-term investors can ignore short-term interest rate movements. If fears of Fed action cause share prices to fall, so much the better. A wise investor will just use that opportunity to buy good stocks on sale.
So stay frosty while dividend stocks and other income-bearing instruments take their lumps.
Rates go up, rates go down, but none of that matters if you’re in it for the long haul.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.