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By Jeremy Glaser and Josh Peters, CFA | 07-25-2013 11:00 AM

Will Rising Rates Derail Dividend Stocks?

A rising-rate environment has historically led dividend payers to underperform, but that is no reason to abandon these high-quality companies, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. I’m here today with Josh Peters. He is the director of equity income strategy here at Morningstar and also the editor of Morningstar DividendInvestor. We’re going to talk about what impact rising rates will have on dividend-paying stocks.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: You’ve looked back at some previous rising-rate cycles and what impact that’s had on higher-yielding sectors. What did you find in that research?

Peters: My look back at rate cycles over the last 20 years did come up with some pretty predictable results, which is that you see a pattern that higher-yielding stocks and higher-yielding sectors within the market tend to underperform a broad market benchmark like the S&P 500 when interest rates are rising. And I used for that reference the 10-year Treasury yield that goes up more than 1 percentage point from the bottom.

On average during these cycles, the S&P 500 has a total return of 11%, which is pretty good. It makes you wonder why investors, in general, should be so worried about rising interest rates. The Dow Jones U.S. Select Dividend Index on the other hand, which is a pretty good benchmark and goes back to the end of 1992, covering this high-yield sector of the market, has had an average total return in these periods of only 3.7%. On average, it's still positive. But there's not much capital appreciation, but there is that relative underperformance.

However, within the numbers, depending on how you want to treat different rate cycles, I actually think that it’s not even that bad. If we exclude a couple of really unusual periods--the immediate post-crash period in 2009 as well as the dot-com bubble era where anything and everything that was associated with old economy, including dividends, was tossed out in the trash--then you have a pretty comparable level of performance. On higher-yielding stocks, the Dow Jones Select Dividend Index only underperformed by a little less than 100 basis points during those rate cycles.

I think having come this far in this rate cycle--long-term interest rates are already up a full percentage point or more from the bottom--we’ve seen the same pattern hold true. High-yield stocks have underperformed, but you’re still making money. You’re still collecting the dividends, and even if you’re not getting as much capital appreciation as the rest of market, you’re still getting some.

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