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By Jeremy Glaser and Josh Peters, CFA | 09-05-2013 03:00 PM

Dividend Risks Worth Taking, and Avoiding

Having interest-rate risk in your portfolio's stock sleeve is an intelligent move, but investors should also be willing to sacrifice returns than seek additional risks, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. I am here with Josh Peters. He is the director of equity income strategy and also the editor of Morningstar DividendInvestor. We'll talk about risk in equity portfolios and what's the right way to think about it. Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Josh, you run some dividend portfolios and a lot of people think about dividends as a way to maybe take some risk off the table. How do you think about balancing that risk/reward when you're purchasing stocks for your portfolios?

Peters: Jeremy, most of the time I talk about my portfolio strategy in terms of the returns. For my [DividendInvestor] Harvest portfolio, I am looking for yields of 4% to 6%, which is more than double the S&P average. But I am also looking for only safe dividends and dividends that are going to grow at least as fast as inflation.

My [DividendInvestor] Builder portfolio, again, I talk about the returns. I am looking for yields of 3% to 4% and high-single-digit or better dividend growth to drive total returns over the long run. But returns are only half the story. A lot of people are going to talk about the returns of a strategy, and you don't get into the risk. Or you get maybe a quantitative assessment of the risk, but you don't get the underlying idea of "What kind of risks are we taking?"

In my September DividendInvestor cover story, I decided to take a look and discuss some of the individual risks that we've sort of taken more of, some of the risks that we've taken less of, and using that as a way to explain our portfolio strategy from a different direction.

Glaser: What are some of the risks that you're willing to take right now?

Peters: Interest-rate risk is the big one, and it's very much top-of-mind for a lots of investors, especially people who are interested in income right now. We've seen this huge move in the long-term Treasury yield, closing in on 3%. It was below 2% only a couple months ago. It seems like it's been forever. That's put a lot of income-producing stocks out-of-favor; certainly bonds are out-of-favor. Money is starting to come out. But is that an intelligent risk we're taking?

When I think about interest-rate risk, every investment security that provides some return of cash in the future has some sensitivity to interest rates. It doesn't matter whether it's AT&T or whether it's Google. Even though Google doesn't pay a dividend, its value today is still a function of future cash flows, discounted back at some interest rate, or discount rate, that's going to be sensitive to changes in interest rates. The question is: Is all else equal or are there offsetting factors?

Now, if you think about why interest rates will typically go up, it's for one or two reasons, either inflation is going up or the economy is growing faster. There is more demand for capital and better opportunities; money comes out of bonds and perhaps goes into stocks. In that kind of environment, you would expect most dividend-paying companies as being more stable, not as susceptible to riding the booms and busts of the economy overall. They're not going to gain as much in a faster-growing economy as some more speculative names or cyclical names might. So, the interest-rate risk tends to hit them a little bit harder.

But if you try to dodge the interest-rate risk and you go with cyclical stocks as a way to get rid of it or mitigate that or just own all speculative names, names that don't pay a dividend at all, then you're taking more economic risk. I want to think in terms of not just any one risk, but how they balance against each other. Interest-rate risk is fine to be concerned about and try to manage and mitigate. But interest rates will come down if the economy, say, goes back into recession or softens, perhaps as a result of interest rates going up. I am first and foremost concerned with getting the dividend income I expect. I don't want those dividends to be cut if we have a recession. For me, interest-rate risk is an intelligent risk to take.

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