The near-zero interest rate environment of the last eight years has driven millions of income-seeking investors into stocks — particularly into those paying out decent dividends. Between the dividends and the rise in stock prices, the strategy has paid off handsomely, with total returns far exceeding the coupons on investment grade bonds.
With valuations near historical highs and interest rates rising in the U.S., however, the game has changed for investors in high-yield, dividend-paying stocks. They no longer have the wind at their backs.
"The competition for capital increases as interest rates go higher," said Greg Ghodsi, managing director of investments at 360 Wealth Management Group, a firm affiliated with Raymond James. "It will pull more money out of stocks and into bonds."
It won't happen overnight, but the signs of a shift in the market are already apparent, with dividend-paying utilities and consumer staple stocks falling in the last several months while the broader market has continued to go up.
Shares in consumer products manufacturer Kimberly Clark, for example, are down 12 percent since the beginning of September while the S&P 500 Index is up almost 7 percent. That fall wipes out the stock's current 3.2 percent dividend yield and then some. Other consumer staples such as Clorox, Kraft Heinz and Proctor & Gamble — all popular alternatives to high quality bonds — have also begun to fall.
"If the staples continue to sell off, that will be a place to find value," said Ghodsi, who has been shifting money to the energy sector since early September. "But I wouldn't buy them right now."
The consumer staples could be a harbinger of a broader shakeout to come among high-dividend-paying companies. High-yield dividend stocks are even more sensitive to rising interest rates. Usually defined as stocks paying out at least 100 basis points more than the 10 year Treasury bond yield (roughly 3.5 percent or more), stock prices for these companies — particularly the lower quality stocks — could be vulnerable if rates continue to rise rapidly.
"People have focused on the yield, not on the potential volatility," said Roger Aliaga-Diaz, chief economist of the Americas at Vanguard Group. The fund company recently closed its Vanguard Dividend Growth Fund after assets more than doubled to over $30 billion in the last three years.
"Dividend stocks are not a good substitute for fixed income investments," he said. "A lot of risk comes with it and we are warning investors constantly about it."
Aliaga-Diaz does not expect interest rates will continue rising as fast as they have in the last six months, but he does expect more volatility in the stock prices of high dividend payers. The highest-yielding sectors are master limited partnerships in the energy space, mortgage real estate investment trusts and business development corporations, with payouts in the 8 percent to 10 percent range.
The two major risks with high-yield dividend stocks are the volatility of the stock price and the vulnerability of the dividend payout. Rising interest rates aren't the only factor affecting these companies, but they increase the risk on both fronts.
As rates rise, the payouts become relatively less attractive to yield-seeking investors and they put more financial pressure on operating performance. A cut in dividend payout typically wreaks havoc on the stock price, regardless of whether it's the best strategy for a company. Witness the plunge in Kinder Morgan's stock after its massive dividend cut a year ago.
Given the lofty valuations across the high-dividend-paying sectors of the market, there is little margin for error. Equity REITs, which have an average dividend yield of just under 4 percent, according to the National Association of REITs, are currently trading at 33 times forward earnings, said Erin Gibbs, a portfolio manager for S&P Investment Advisory Services. Utilities trade at a lower 17 times forward earnings, but the sector is also expected to see a 1.3 percent decline in earnings in the coming year.
"Valuations [across high-dividend-paying sectors] are at the top of their historical ranges," said Gibbs, who helps manage the S&P Dividend Income and Growth Fund. The fund invests in high-quality stocks with at least a 10-year record of increasing earnings and dividend payouts.
She, too, expects a slow shift in the market's asset preference back to debt as interest rates rise and that could challenge stock prices of high yield companies going forward. "I'm not expecting them to be out-performers in the coming year," she said.
Her fund is still up 17 percent in the year to date versus 10 percent for the S&P 500, but she said it has lost about 2 percent of its outperformance in the fourth quarter.
Regardless, she is still recommending high-quality dividend stocks to her conservative investors. "They don't go up as much as the market but they don't come down as much either," said Gibbs. "I expect some dips, but companies with high yields, rising earnings and rising dividends are lifeboats in volatile markets."
With expectations that President-elect Trump and a Republican Congress will lower corporate tax rates, one sector of the market currently drawing a lot of interest from investors is dividend payers with high effective tax rates — most notably retailers. They should see a relatively big benefit from corporate tax reform.
Ghodsi at 360 Wealth Management Group expects rising interest rates will result in a more normal market dynamic with the focus on global growth and a rotation into undervalued sectors like banking and energy. "I think many high dividend stocks are still overpriced, but I don't think a couple of rate increases will dramatically change the positive dividend dynamic."
— By Andrew Osterland, special to CNBC.com