By Philip van Doorn, MarketWatch
Justin Sullivan/Getty Images
If you’ve been buying stocks for their dividend yields, you might be in for a surprise if interest rates march higher.
That’s why it’s time to be more selective, said Bill McMahon, chief investment officer of dividend-investment specialist ThomasPartners. He highlighted five stocks, which we’ll review, that he still finds attractive based on valuations and dividend-growth potential.
The hottest sectors in the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.50% this year are telecommunications and utilities. The telecommunications sector, dominated by AT&T Inc. /zigman2/quotes/203165245/composite T -1.09% and Verizon Communications Inc. /zigman2/quotes/204980236/composite VZ -0.83% , is up 12.7%, and the utilities sector has risen 11.1%. The energy sector has risen the most, propelled by oil prices that rebounded from a 14-year low.
Investors “like dividend yields, since they can replace what bonds used to do for them. And they like low volatility, to avoid fritting away the dividend income,” said McMahon. His team at ThomasPartners, a subsidiary of Charles Schwab Corp. /zigman2/quotes/201281754/composite SCHW -2.13% headquartered in Boston, manages about $9 billion in assets in client accounts.
But when you’re considering dividend stocks for long-term investments, aiming for bond-like yields might not be what’s best. Could you ride out volatility that may lie ahead? Have you done so before?
This chart shows the recent rise of the CBOE Volatility Index, after remarkably low volatility during July and August:
Mark Hulbert recently showed the importance of riding out periods of volatility, based on the four market dips that the S&P 500 recovered from over the past year. But even though he makes a strong case for sticking with your objectives and not selling into panics, it’s human nature to do so.
The danger of bond-like stocks
If a stock has a juicy yield, but the company isn’t increasing the dividend significantly, the ride could be rough if you buy at today’s prices. Don Taylor, who manages the Franklin Rising Dividends Fund, recently discussed how a rapidly growing payout can protect against downside risk as interest rates rise, and also named three favorite dividend stocks.
McMahon at ThomasPartners said long-term bond investors who recently migrated toward bond-like stocks — the ones with high yields but slow earnings or dividend growth — are likely “to gravitate back to their preferred habitats. There is a risk of flight if you see a higher interest rate environment.”
In an interview, McMahon was careful to say he considered a high-rate environment “far-fetched, given where interest rates are globally,” but as we saw on Friday, when the S&P 500 declined 2.5%, concern over a modest increase in rates by the Federal Reserve can lead to panic. (The Federal Open Market Committee holds a meeting Sept. 20-21 and again in December. Market participants see a 25% chance of a rate increase in September and a 44% probability in December, according to CME Group.)
Shares of AT&T, for example, closed at $39.71 Friday, sliding 3.4% on interest-rate fears. The shares have returned 20% this year, through Sept. 9, with dividends reinvested. This is a solid company with a quarterly dividend of 48 cents a share, for a yield of 4.84%, which is very attractive when 10-year U.S. Treasury bills /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -0.37% yield roughly 1.7%.
But AT&T’s board of directors has long been in the habit of raising its dividend by a penny a year, which worked out to just 2.1% when the company last increased the payout in December. This slow growth for the dividend places it in the bond-like category that McMahon mentioned, and this year’s runup in the stock price, combined with Friday’s panic, perfectly illustrate how risky the stock can be if you’re not patient.