Despite recent relief in rates and the Fed tapering non-event, interest rates will increase over the next couple of years. The end to the 30-year decline in yields may be over and rate-sensitive sectors could underperform even after their strong dividends. Positioning your portfolio in economically-sensitive stocks could help boost returns and keep your dividend yields safe.
An end to the 30-year bond bull market
While rates have come down a bit from their high this year, yields on the 10-year treasury are more than 1.25% off their 2012 lows. The mere hint that the Federal Reserve might start to taper its historic buying program sent rates surging more than a percent in less than three months.
This has led many, including bond guru Bill Gross, to call an end to the 30-year bull run in the fixed-income market. Rates on the 10-year benchmark topped almost 15% in 1982 and have come down at a fairly constant rate over the last three decades. As rates decrease, bond prices go up so investors have enjoyed regular interest payments as well as capital gains on their bonds.
Now assumptions about the safety of fixed-income investments and some rate-sensitive sectors of the stock market have been called into question. The Utilities Select Sector SPDR (XLU) has plunged more than 10% since rates started rising this year, destroying the meager 3.9% yield on the fund. Other sectors like real estate investment trusts (REITs) and consumer staples have also been hit hard.
The bad news is that rates are bound to increase further over the next few years. The Federal Reserve must eventually start to unwind its massive asset program or threaten its own credibility. Economic growth has picked up in China and the eurozone which will help to support global growth.
Defense in non-defensive names
The good news is that your dividend portfolio doesn’t have to languish along with the rise in rates. The rise in rates should only occur with stronger economic growth which means cyclical sectors like materials, technology and consumer discretionary should do well.
The Dow Chemical Company (DOW) produces a wide range of chemicals across six major segments; electronic and functional materials, coatings and infrastructure solutions, agricultural sciences, performance plastics, performance materials, and feedstocks and energy. The shares trade a little pricey at 17.8 times trailing earnings but an economic recovery means higher demand for chemicals and strong earnings for the leader in the industry. The company pays a sustainable 3.3% yield and has paid out a dividend for almost four decades.
Seagate Technology (STX) manufactures and sells electronic data storage devices. Between the ever higher storage requirements for new programs and an increase in business spending on a stronger economy, Seagate is well-positioned for growth. The shares trade for 9.5 times earnings, well under the industry average of 18.8 times though slightly above the company’s 5-year average of 8.1 times earnings. The dividend payment, now at a 3.3% yield, has been increased at a 25% compound annual rate over the last ten years.
Six Flags Entertainment (SIX) operates 18 theme parks in North America and should do well on a pickup in economic growth and spending on recreational activities. The shares trade for just 9.2 times trailing earnings and a rollout of new attractions to its parks in 2014 could boost profits. The 5.5% dividend yield is well covered by increasing free cash flow over the last three years.
Diversify your dividend names
The steep rise in rates between May and July was exaggerated by markets that thought the Fed would continue its quantitative easing program forever. While rates will increase, they will probably do so in a more moderate manner. This means that even rate-sensitive sectors could provide a decent return but you may want to look for more cyclically-sensitive sectors for higher returns and dividend safety.