When fixed income professionals think about a stress scenario that features a sharply higher yield curve, the conversation turns to 1994. In January 1994, the U.S. economy was thirty-four months into an economic expansion following the 1991 recession. Interest rates were historically low for the time. (The 10-yr Treasury opened the year at 5.83%, a level that had not been seen since 1971.) The Savings and Loan crisis was largely in the rearview. Inflation was low and stable, a Democratic White House had made a pledge to close the budget deficit that was ultimately successful.
Bondholders got crushed. Below is a graph of the ten-year Treasury yield for 1994. A holder of the ten-year Treasury would have had a total return of close to -10% as yields rose and bond prices fell.
Source: Bloomberg, U.S. Treasury
In the current market environment, dividend stocks have been strongly underperforming the broader market recently as modestly higher rates presumably make dividend stocks less attractive to fixed income alternatives. The market assumption appears to be that the price of dividend stocks must drop to increase the yield relative to now higher yielding fixed income alternatives. The question I am posing is whether this was the case in 1994? Is this expected market move based on historical precedent?
It was certainly not the case in 1994. Dividend stocks produced total returns roughly equal to the broader market despite the 200bp backup in the 10-year U.S. Treasury. While dividend stocks lagged early in the year during the early phase of the bond market rout, they outperformed late in the year to produce total returns roughly equivalent with the overall market. Below is a graph of the S&P 500 cumulative total return in 1994 relative to the total return of the S&P Dividend Aristocrats (proxied through SDY).
Of course, fast forward from 1994 to today and dividend stocks have strongly outperformed the broader market. While dividend stocks lagged during the tech bubble run-up in the late 1990s, stable dividend payers outperformed in the 2000s, especially during the large market drawdowns in 2002 and 2008 as graphed below.
Source: Bloomberg, Standard and Poor's
In past articles, I have demonstrated the long-run outperformance of companies that steadily increase dividend payouts and long-run outperformance of low volatility, high dividend payers. I do not expect that the recent sizeable underperformance of dividend paying equities will continue even as interest rates normalize. This was not the case in 1994 in a much sharper interest rate move than I am anticipating in 2013. For example, utility stocks in May underperformed the S&P 500 by the most since the Enron bankruptcy in late 2001 even as Berkshire Hathaway (BRK.A, BRK.B) increased their utility holdings through the purchase of NV Energy (NVE). The underperformance of high dividend payers appears disconnected to the size of the interest rate move we have witnessed and the scope of future interest rate moves currently priced into the forward curve. If dividend stocks meaningfully underperform the market, long-term investors should look to add strong companies who pay steady and increasing dividends.