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By Jeremy Glaser and Josh Peters, CFA | 07-23-2012 11:00 AM

That Good Dividend Yield Now Might Not Look So Good Later

Although the economy needs to improve before the Fed raises key rates, some dividend payers might act as good hedges amid higher rates, while others have something to lose, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Federal Reserve keeping interest rates at record lows, many are turning to dividend stocks for yield, but what will happen to those stocks as interest rates begin to rise again? To answer this question, I have Josh Peters. He is editor of Morningstar DividendInvestor.

Josh, thanks for joining me.

Josh Peters: Good to be here.

Glaser: So, let's take a look at your outlook for interest rates first. I think certainly nobody knows for sure when rates will start to look a little bit better or start to rise. When would you expect the Federal Reserve to act?

Peters: Well, I try never to have a very specific forecast. I think that's really a mistake for investors to say that they have a very clear outlook on exactly where rates are going to go and then trying to position themselves around a specific forecast. I like to think in terms more of hedges. So, interest rates could go up certainly from where they are now. They might also go lower. They could just stay here for a while. [Asking] how will my portfolio perform under some different circumstances and what kind of stocks do I own to meet those challenges, I think that's the right way to think about it, is in terms of risk control.

But at this point, I actually have a little bit stronger view on the long-term outlook for interest rates than I would normally have because I think the Fed really has the power to keep interest rates, at least on the Treasury curve, very low for an extended period of time, in part because of its own buying power, and in part because of people's liquidity preferences and [willingness] to hold bonds, even in a very low interest rate environment. The Fed's requirement that banks hold more liquidity, that winds up going into the Treasury market. I think that's something of a structural shift. So, I don't really doubt the Fed's ability to hold interest rates very low.

Now, at some point, you would expect inflation starts to pick up and then the Fed needs to respond. Well, what happens before that happens is a good way to think about it. I don't think we can really see a significant shift up in interest rates until the housing market has recovered in the context of a broader economic recovery, and housing specifically is now on a path where the prices can be stable or even rise a little bit even if interest rates start to creep up a little bit. Of course mortgage rates have a very large impact on the value of residential real estate. How long will that take? I mean even if the housing market is really starting to recover right now, it might be two or three years or more before monetary authorities are confident enough in that recovery to start taking some actions on interest rates. So, I think we could be in here for a period where 1.5% 10-year Treasury could start to look normal for a while.

Glaser: You've mentioned that investors need to think about hedges then, of how to prepare themselves for rising rates. What dividend-paying stocks do you think are going to perform better in that environment? Which ones do you think are going to do worse?

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