In a Rising Rate Environment, Can You Still Generate Dividend Income?

Includes: HYG, IYR, PFF, REM, TLT
by: Jim Farrish

Are dividends out as growth starts to find its footing in an improving economy? The rant in the headlines is about selling bonds relative to rising interest rates. Yields on the 30-year Treasury bond have risen from 3.5% in August to 4.5% currently. If you own iShares 20+ year Treasury Bond ETF (NYSEARCA:TLT), you have seen the value drop from $109 to $92 (down 15.6%) during the same period. Thus, the ranting or warnings have been warranted as investors holding Treasury bonds have seen their principle values erode. Bonds as a sector have declined just over 7% in principle value.

The transition from safety to risk by investors is part of the reason for the decline in bond prices, but the primary driver has been a gradually improving economy pushing the long end of the yield curve higher. Confidence is rising in the sustainability of the current economic growth pattern. There are even rumors of job growth returning in the U.S. The equity bears could be headed back into hibernation if this trend continues.

The question still remains: Can investors put bonds or other dividend producing assets in their portfolios? The answer is a double-edged sword: Yes, if you manage the risk of the underlying asset. As investors seek to find ways to generate income from their portfolios, they still have to manage the risk of those assets. In a recent discussion with a client relative to buying bonds for income, we recommended some alternative ways to capture income as rates rise. It is important to understand that most bonds do carry risk of principle erosion in rising rate environments; however, you can manage the risk accordingly and capture the dividend income.

Preferred stocks are one area to dig into and consider relative to the current market environment. For example, iShares S&P US Preferred Stock Index ETF (NYSEARCA:PFF) is paying a 7% dividend currently. Prices are stabilizing after a pullback from the highs in August. Relative strength in the sector is rising and they offer an opportunity to capture the dividend. The ETF structure allows multiple ways to manage the downside risk.

High-yield corporate bonds are attractive as the yield spread compresses. iShares IBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) has established a recent low near $88 and has moved higher with money rotating into the sector. The current dividend payment of 7.5% is attractive to investors along with the ability to manage the downside risk with the ETF format is attractive.

REITs are an additional format for generating dividend income for portfolios. The recent decline in the sector has drawn some bad reviews from analysts, but like most investments, not all REITs are created equally. iShares DJ U.S. Real Estate Index ETF (NYSEARCA:IYR) looks similar to the chart of high yield bonds. The selling in November and again in December were in response to rising rates. The price has since stabilized as investors realize the reality of the current rate increase on these funds. The current dividend yield is 4.2% on IYR, but you can scan through the sector to find higher yields in the more specialized sectors. For example, iShares FTSE NAREITs Mortgage Index ETF (NYSEARCA:REM) pays a 9% dividend. Digging through the sector offers other opportunities if you are willing to do some homework.

As interest rises and impacts the Treasury bond sector, there remain other opportunities to capture dividends and maintain the income from your portfolio. As with any investment, they come with risk. While risk is a dirty four-letter word, it is managable. Take the time to sift through the opportunities and find the right fit for your portfolio and your needs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.