A version of this article previously appeared in the October 2019 issue of Morningstar ETFInvestor. Download a copy here.
There's a lot to like about dividends. Getting a regular check in the mail from the companies you own is a testament to their discipline, the health of their business, and their confidence in its future. But the stock prices of firms with stable cash flows tend to be more sensitive to fluctuations in interest rates than those with more-volatile cash flow streams. Here, I'll examine this relationship in more detail to understand whether it's something investors should sweat over.
Asset Prices and Interest Rates Down by the Schoolyard Imagine interest rates and asset prices as kindergarten pals mounted on either end of a seesaw in the schoolyard. As rates rise, asset prices tend to fall. When rates come down, asset prices get a lift. These ups and downs are most pronounced for long-lived assets that produce predictable cash flows, like long-duration bonds.
While their cash flows may not be as stable or reliable as bonds', dividend-paying stocks tend to exhibit a similar relationship with interest rates. Historically, the highest-yielding stocks have underperformed those that either don't pay dividends or have lower yields during periods of rising interest rates. The inverse has been true when rates have fallen: High-yielding stocks have trounced their less-generous peers.
Exhibit 1 illustrates this relationship. I looked at monthly changes in the 10-year Treasury yield dating back to 1962. In defining interest-rate environments, I counted the 25% of greatest month-to-month increases in 10-year yields as "up" periods, the middle 50% as "steady," and the 25% greatest month-to-month declines as "down." Using data from Kenneth French's Data Library, I examined the performance of U.S. stocks across each environment, breaking the universe into dividend payers and nondividend payers and sorting based on dividend yield.
The performance differences among stocks in the highest- and lowest-yielding deciles are pronounced during periods when rates are rising or falling. However, those spreads narrow significantly when rates are steady. And over the full period, the performance differential between high- and low-yielding stocks narrows further still.
Exhibit 2 features the results of a regression analysis I ran on each stock portfolio's returns. I used the market risk premium and monthly changes in the 10-year Treasury yield as explanatory variables. The coefficients in the table indicate how sensitive each portfolio is to changes in the variable in question. A positive value indicates that the two tend to move in the same direction. A negative value indicates an inverse relationship.
Equity risk was least pronounced among those that show more bondlike characteristics--the ones that throw off regular cash flows to their investors. These firms tend to be mature, and their businesses tend to be less cyclical than most. These factors allow them to commit to paying and--in some cases--growing their dividends over time. The market tends to punish firms that cut their dividends, so firms with more-volatile cash flows are likely to be more conservative with their dividend policies.
While higher-yielding stocks tend to have a low degree of sensitivity to market movements, they have a strong negative relationship with interest rates. That's no coincidence. Because they tend to have more-stable cash flows, higher-yielding stocks tend to have less growth when the economy is doing well to offset the negative impact of rising rates than lower-yielding stocks. Conversely, they get more of a lift when interest rates fall.
Sorting on Size To better understand the relationship between dividend yields and interest-rate sensitivity, we need to connect the dots with companies' fundamentals. Dividends are often a sign of maturity. As companies progress through their life cycles, their growth slows and reinvestment needs decline, allowing them to distribute more cash. Using market cap as a proxy for maturity, this evolution is evident.
Exhibit 3 shows the results of a regression analysis I ran on SPDR S&P 500 ETF SPY, SPDR S&P MidCap 400 ETF MDY, and SPDR S&P 600 Small Cap ETF SLY. I used these funds as proxies for their respective strata of the market-cap ladder. As was the case with the output featured in Exhibit 2, I used the market risk premium and monthly changes in the 10-year Treasury yield as explanatory variables.
The relationships here are clear. Large caps tend to be less sensitive to the market and more sensitive to changes in interest rates than their smaller-cap peers. This aligns well with the general characteristics of larger firms relative to their smaller counterparts. Specifically, they tend to be more mature and better capitalized, and may have more-diverse revenue sources. These attributes lend themselves to less market sensitivity and a greater ability and propensity to return cash to shareholders via regular dividends.
Sorting by Industry While looking at interest-rate sensitivity across market-cap strata helps ground this relationship in firms' fundamentals, the picture is still far from complete. Zooming in further and examining how this relationship varies across industries paints a more vivid portrait. Exhibit 4 contains the results of a regression analysis I ran for 12 industry portfolios sourced from Kenneth French's Data Library. Once again, I used the market risk premium and monthly changes in the 10-year Treasury yield as explanatory variables.
Those industries that are generally deemed defensive in nature--owing to inelastic demand for their offerings and ample pricing power--are most sensitive to changes in interest rates. These include utilities and consumer nondurable goods. Companies operating in these industries tend to produce steadier cash flows, and thus tend to suffer as rates rise and get a boost when they fall. More-cyclical industries like business equipment and manufacturing exhibit the opposite relationship. Demand for their output tends to ebb and flow with economic output, as do their cash flows. As such, they tend to get a tailwind from rising rates (which tend to be indicative of a growing economy, inflation, or both) and are hamstrung when they fall (often coincident with a softening economy).
Funds in Focus Now I'll drill down further, applying this same lens to the universe of dividend-oriented exchange-traded funds that invest in U.S. stocks that are also Morningstar Medalists. I've run these 10 funds (and one index, which underpins Fidelity Dividend ETF for Rising Rates FDRR) through the same regression analysis outlined above. In Exhibit 5, they are ranked in order of their interest-rate sensitivity, which I measured from the nearest inception date of the 10 funds.
We see that WisdomTree U.S. SmallCap Dividend DES has been the least sensitive to changes in interest rates and the most sensitive to movements in the broader market. Digging into the fund's portfolio shows a combination of overweightings in cyclical sectors like materials and industrials, which tend to move in tandem with interest rates. Furthermore, the DES is underweight in sectors like telecoms and financials that tend to move in the opposite direction of interest rates.
At the bottom of the rankings, we find Invesco S&P 500 High Dividend Low Volatility ETF SPHD. This fund has both the lowest market beta and highest sensitivity to changing rates. The fund's index ranks all stocks in the S&P 500 by their 12-month-trailing dividend yields (excluding special dividends) and screens for the 75 highest-yielding names. It then ranks them on their realized price return volatility over the prior 12 months and targets the 50 least-volatile names. Stocks that make the cut are weighted by dividend yield. This yields a portfolio with big overweightings in the most rate-sensitive sectors. As of Oct. 1, 2019, its combined allocation to utilities and real estate was nearly 32 percentage points greater than the Russell 1000 Index's.
Don't Sweat Rising Rates It can be helpful to understand how dividend-paying stocks and the funds that own them are affected by fluctuating rates. But it's important not to conflate awareness and understanding with a call to action. Rates will rise and fall, and no one knows when or by how much. Owning quality companies that regularly return cash to shareholders is a solid strategy for all rate environments.
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