High-dividend-paying stocks tend to be more sensitive to interest rates than their lower-yielding counterparts, but not for the reason you might think.
Rising interest rates can clearly hurt investment returns. As rates rise, the expected returns for all securities must increase to stay competitive, which often requires prices to fall. While it is more difficult to estimate the interest-rate sensitivity for stocks than bonds because their cash flows aren't fixed, some stocks clearly have greater interest-rate risk than others. For example, high-dividend-paying stocks have tended to be more sensitive to interest-rate fluctuations than their lower-yielding counterparts. It may be intuitive to surmise that this is because investors pile into higher-yielding stocks when interest rates fall to make up for lost income and move that money back into fixed-income assets when rates rise. But a closer look suggests that differences in cash flow volatility can better explain this relationship.
High-dividend-paying stocks have historically underperformed their lower-yielding and non-dividend-paying counterparts when interest rates were rising. The opposite has been true when rates were falling or constant. To uncover that relationship, I looked at return data from the French Data Library for non-dividend-paying stocks and dividend-paying stocks representing the 30% with the lowest yields, the middle 40%, and the 30% with the highest yields from May 1953 through December 2016. I ranked the monthly changes in the yield on the 10-year Treasury note and defined the quartile of months with the biggest jump in yields as periods of rising interest rates. The bottom quartile represents a falling-rate environment, while the middle 50% represents a constant rate environment. I then looked at how each of the four dividend portfolios performed in those three interest-rate environments. The table below shows the annualized returns for each portfolio.
I also ran a regression analysis on these portfolios' excess returns using the market risk premium and changes in the 10-year Treasury yield as explanatory variables. This approach allows us to control for fluctuations in the market and isolate how changing interest rates affect the performance of each portfolio. The coefficients from these regressions, presented in the table below, indicate how sensitive each portfolio is to both changes in the market and interest rates. A positive number indicates that the performance of the portfolio moves in the same direction as the corresponding variable, while a negative number indicates an inverse relationship. For example, a market beta of 1 indicates that the portfolio increases 1% for each 1% increase in the value of the market. These results corroborate the findings above. Interestingly, non-dividend-paying stocks and low-yielding stocks tend to move in the same direction as interest rates (holding the market constant), while higher-yielding stocks tend to move in the opposite direction.
To interpret these results, it is important to realize interest rates don't change in a vacuum. They tend to rise when the economy is strengthening and fall when it is weakening. Companies that are less sensitive to the business cycle tend to have less cash flow growth during economic expansions to offset the negative impact of rising rates on their prices (so they underperform). But they tend to hold up better during economic downturns when rates usually fall.
Dividend-paying stocks tend to have more-stable cash flows than their non-dividend-paying counterparts (their lower market betas support this) for two reasons. First, these are generally more mature firms. Second, these companies wouldn't commit to regular dividend payments if they weren't confident in their ability to honor them throughout the business cycle. Consequently, their cash flows tend to be less sensitive to the health of the economy and interest rates than non-dividend-paying stocks'. With less cash flow growth to offset the negative effect of rising interest rates, high-yielding stocks behave more like bonds than do their stingy peers and are more likely to suffer when rates rise. But their stable cash flow also works to their advantage when rates fall.
If this explanation is accurate, more-defensive sectors should underperform in a rising-rate environment and outperform in a falling-rate environment. That's exactly the pattern the data show. I ran the same regression as described above on several industry groups from the French Data Library from May 1953 through November 2016. The table below illustrates the results.