Even though rates have come down significantly over the last month, the risk is still to the upside for the rest of the year. The relative strength of the U.S. economy will drive the Fed to continue tapering its asset purchases and a headline unemployment reading below 6.5% will increase calls to raise rates. Dividend investors should use the recent reprieve to re-position their portfolio into sectors that will do well in a rising rate environment against the more traditional safe-haven dividend sectors.
A top-down approach to dividend investing
Most likely, your dividend portfolio has a bias to sectors like utilities and consumer staples. The companies in these sectors typically are in mature industries and have strong cash flows with limited growth prospects. Payout ratios are high but share price appreciation is usually limited and the overall investment behaves more like a bond than like other stock investments.
That is a problem when interest rates increase. Since payments and the yield to maturity are relatively fixed compared to other investments, those other investments look more attractive as rates increase. The market reaction is usually a selloff in the price of shares to bring the cash yield up higher and competitive with other investments.
Finding sectors that perform well in a rising rate environment is easy enough. The simplest way is by comparing returns against the iShares 20+ Year Treasury Bond Fund (TLT) during periods of higher rates. Choosing potential sectors means comparing relative returns with a fundamental rationale for doing well when rates rise as well.
For this article, I charted the returns to the Select Sector SPDR Funds against the treasury fund for the period May 1st to August 21st of last year. Over the 16-week period, rates on the 10-year bond increased almost a full percent and the treasury fund lost 18% of its value.
The Industrial Select Sector SPDR (XLI) outperformed all nine sectors over the period with a return of 8.8% and offers a yield of 1.7% annually. The outperformance in the sector is explained by its relationship with the business cycle. Rates increase on the expectation of stronger economic growth or inflationary pressures ahead. Higher economic growth means stronger demand for industrial products like capital equipment and professional services. While the yield on the sector fund isn’t something that would get a dividend investor excited, there are individual opportunities within the sector that offer better yields.
The Financial Select Sector SPDR (XLF) also did well with a return of 7.1% and an annualized yield of 1.5%. Banks and other financial institutions make much of their profits from the spread on interest rates. Since the Federal Reserve has committed to near-zero rates at the short end of the curve, higher long-term rates means higher profits for lenders. The KBW banking index jumped almost 15% over the period as banks looked to better times ahead.
High yields and strong share gains
The benefit of looking outside of traditional bond-like dividend payers is the potential for share price gains. While these sectors and stocks may be relatively more volatile than utilities or other defensive sectors, they can provide a big boost to your portfolio when the economy is rebounding.
BB&T Corporation (BBT) jumped 16.4% over the period studied and offers a 2.5% dividend yield. The company operates in the Southeast with 1,832 branches in 12 states and the District of Colombia. The bank was able to increase income by 6.1% in the fourth quarter on strength in its community banking segment even as revenues decreased by 6% over the quarter. The decrease in sales was a factor of weak mortgage business and should improve over the year as the rebound in housing continues.
Shares of Huntington Bancshares Inc. (HBAN) increased over 20.1% during the 16-week period last year and pay a 2.2% yield. Shares of the $7.3 billion Midwestern lender are down more than 11% since a weak fourth quarter report failed to match expectations. A 5.7% decline in profits on the quarter was largely a result of a 61% decline in mortgage banking income. A significant part of the weakness was weather-related and should rebound in the first or second quarter.
On the industrials side, shares of Cummins Inc. (CMI) bounced 19.1% higher over the period studied and pay a 2.0% yield. The company books almost two-thirds (60%) of its sales in North America which should benefit it as the U.S. looks to lead global growth in developed markets. The company should benefit this year from stronger deliveries to PACCAR (PCAR) and the project with Westport Innovations (WPRT) may finally start to bear real fruit.
BB&T and Cummins performed in-line with the S&P 500 last year while Huntington Bancshares outperformed with a 43% return. Results are less favorable over the last few weeks, which should be expected on weaker economic data and lower rates. The overall economy is fairly strong and the recent turmoil will not derail the Fed’s taper plans or higher rates. Take advantage of the selloff to add some diversification to your dividend portfolio in sectors and stocks that do well when rates increase.