Rising interest rates are bad for dividend-paying stocks. At least, that is the conventional wisdom, which sees higher yields on cash and bonds diminishing the appeal of equity income, and higher borrowing costs for the kinds of indebted telecom, industrials, and consumer-related businesses that also tend to pay dividends.
So, how have dividend payers fared amidst rising rates in 2022? While central banks across the globe aggressively hike rates to combat inflation, the Morningstar Developed Markets Dividend Yield Focus index is down just 1% for the year through October, while the broad equity market benchmark from which it’s derived has declined roughly 20%.
Now, we are told that rising rates are bad for growth stocks because higher interest rates devalue their long-dated earnings. What’s more, stocks and bonds have simultaneously swooned, making us question everything we thought we understood about markets. What on earth is going on?
A range of factors has boosted dividend payers in 2022
For one thing, the only global equity sector in positive territory in 2022 is energy, and energy stocks tend to be dividend rich. Even before the Ukraine war sent oil prices surging, supply/demand imbalances had pushed oil prices to their highest levels since 2014. It’s a remarkable comeback from April 2020, when the pandemic pushed oil futures into negative territory.
On the other side of the ledger is the technology sector, which has led the market down in 2022. Dividend indexes tend to be light on low or no-yield technology stocks, but they have come to represent a growing share of the global equity market in recent years. High-fliers have the furthest to fall in crashes.
Meanwhile, consumer staples, utilities, and healthcare stocks – sectors rich in shareholder payouts – have all lost less than the market this year. As fears of recession mount, companies providing nondiscretionary products and services have found themselves in favour.
Finally, while the yield on the Morningstar Global Treasury Bond Index has more than quadrupled since the start of 2022, fixed income has been a disaster from a total return perspective. Bonds may not have fallen quite as far as equities, but losses of more than 10% on an asset class considered “portfolio ballast” has surprised many investors. In previous equity market downturns, high quality bonds were a safe haven. Clearly, the relationship between assets is not fixed.
Dividend outperformance in 2022 is no anomaly
When the historical record is examined, the relationship between dividend payers and interest rates looks fuzzy. There have been plenty of periods, like mid-2004 to mid-2006, when the Fed jacked up its funds rate from 1% to 5.25%, but dividend payers outperformed the market. Dividend-rich financial services stocks were booming at that time, and energy and material were riding a "commodities supercycle" driven by China's economic growth.
In the late 1990s, rate cuts failed to help dividend payers, because the market was fixated on tech stocks (earnings weren’t necessary, let alone dividends). In short, the broader context is crucial. A confluence of factors is always at play.
Globally too, dividend payers do not respond predictably to interest rates. We tested the relative performance of dividend payers during different rate regimes in the UK, Germany, Japan, and Australia. No clear relationship emerged, except one: the high-yield segment of the equity market outperformed over time.
Focus on fundamental, not macro factors
Dividend paying stocks have a strong long-term track record, not just for income but also total return. Dividend payers tend to be solid, established businesses, and the dividend commitment focuses corporate management on steering a steady ship. Investors who rely on their shares for a payout may be more likely to ride out price fluctuations.
Though dividend payers have been a wonderful means of participating in equity markets, investors need to beware yield traps. When a stock's price declines, its yield rises. So, high yields are often found in troubled sectors, industries, and securities that ultimately cut their dividend due to financial distress.
During the global financial crisis of 2007-09, companies with decades-long dividend histories slashed payouts. The same was true in 2020, when the pandemic-driven economic collapse led more than one third of the dividend payers tracked by Morningstar to reduce, suspend, or eliminate payouts. A company can be an equity income champion, until it is not.
For this reason, quality, financial health, and dividend sustainability are key considerations. Rather than worrying about interest rates, equity income investors would do well to focus on fundamental factors.