The laws of gravity may dictate that what goes up must come down, but interest rates seem to have their own converse course of action - what goes down eventually will go up. Although it seems like interest rates can stay stuck in low gear for years, (decades even, in the case of Japan) eventually they will creep higher, and talk is heating up about the timing and magnitude of such creep in the US. As the portfolio manager of Franklin Rising Dividends Fund, Don Taylor was quick to comment that higher interest rates don't mean all dividend-paying stocks are doomed.
Since bond prices typically move in the opposite direction of interest rates, a rising rate environment erodes the value of bonds in a portfolio. Just how interest rate-sensitive are dividend-paying stocks? And how does that affect investors who may have sought refuge in them as a source of yield? Taylor explains.
"The more bond-like the stock, the more sensitive it is to interest rate movements. The more equity-like and the less bond-like, the less correlation, generally speaking. For the equity market overall, if bond yields are rising because of more confidence in and sustainability of an economic recovery-and in a period like this where inflation remains incredibly well behaved-equities have the potential to perform well at the same time interest rates are moving up. You can't lump all dividend-paying stocks into the same bucket. The most bond-like parts would be the most vulnerable [to rate increases]."
So what stocks are "bond-like"?
"Most dividend-paying stocks (which represent some 80% of the S&P 5001) aren't particularly sensitive to interest rate movements. But some of them are, and it's likely to be the ones with the highest payout ratios that have the characteristics we might classify as most bond-like. That is, the high payout-ratio companies tend to be higher-yielding companies. Examples of those types of stocks would be utilities and telecom, which we don't own in the Rising Dividends Fund because they are not dividend-growth focused.
"We focus on companies more apt to have the ability to increase their dividend. Nowadays multiples are very high on high-dividend payout ratio companies; it's a powerful incentive for companies to have more emphasis on dividends as part of the capital allocation process. So I think, in addition to dividend growth coming from the growth of the business, we are in a phase of companies further increasing their dividends. "
What that says to me is the most equity-like part of the bond market has gotten very expensive relative to bonds overall, just as the most bond-like part of the equity market had gotten very expensive relative to stocks overall, making those areas vulnerable.
"There is a lot of concern about whether the dividend yield story is overdone, and I think the concern is legitimate. However, I think the dividend growth story is completely different."
While Franklin Rising Dividends' portfolio is focused on US companies, many US-based companies do business-sometimes a lot of it-outside the US. So while US interest rates and other US economic factors should be an influence, they're not the only influence on profitability. Europe is a particular area of concern right now for some investors, but Taylor said the companies in the portfolio have so far been weathering the challenges.
"Companies in our portfolio are sensitive to global growth, but most sensitive to the US, and we are in a period where among developed countries, the US appears to be one of the strongest growth stories. Within Europe, (our) companies' exposures are overwhelmingly in Germany, the UK, and some other northern European countries. Very few companies have meaningful exposures in the weakest European countries. So although Europe certainly isn't a big source of growth for companies in our portfolio, it doesn't affect them overall that much and the companies are still finding a lot of opportunity in emerging markets, where there have been good growth rates."
As many global companies aren't totally dependent on one market for growth, they aren't dependent on rates staying near zero forever, either. While there's a lot of talk right now about rising rates, Taylor adds that it's an interesting discussion, but probably a bit overblown.
"I personally don't think bonds will get crushed any time soon, and therefore there's probably going to be some stabilization of pure yield-oriented strategies. But that's another story."
What Are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. While smaller and midsize companies may offer substantial opportunities for capital growth, they also involve heightened risks and should be considered speculative. Historically, smaller- and midsize- company securities have been more volatile in price than larger company securities, especially over the short term. These and other risks are detailed in the Franklin Rising Dividend Fund's prospectus.
1. Source: FactSet, as of 5/31/13.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.