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Will Rising Rates Sink Dividend Payers?

Higher rates will be a headwind for defensive dividend payers, but there are still some relative bargains.

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference. 

Morningstar Research Services' Alex Bryan and Travis Miller, Morningstar Indexes' Dan Lefkovitz, and Morningstar Investment Management's Mike Hodel sat down in the first session of the Morningstar Investment Conference on Wednesday to explore the state of dividend investing.

The first topic on deck was what impact a rising rate environment is going to have on dividend payers. Bryan pointed out that historically as interest rates have headed higher that has been in a tremendous headwind for higher-yielding stocks. He pointed out that rate increases don't happen in a vacuum, and that rates are generally going up in times of economic expansion. A booming economy is generally good for cyclical firms, while more defensive stocks (which are the ones most likely to pay high dividends) are likely to lag. He thinks this helps explain the relative underperformance.

If rates are set to move higher, what does that mean for valuations? Overall the panel saw valuations of dividend paying stocks (and of the entire market) to be overvalued, but there are some pockets of relative opportunity. Lefkovitz said the valuation premium for his dividend indexes is much smaller now than it was earlier on in the recovery. Miller said the spread between the S&P 500 yield and the 10-year Treasury yield is unusually narrow, which is leading to some attractive relative values in wide- and narrow-moat Utilities. Healthcare was seen as the sector with the most attractive opportunities today.

What should investors do then? Hodel and Bryan advocated for taking the long-term view. If it makes sense to have part of your portfolio allocated toward dividend income, then you should stick with that allocation even if there will be some rate headwinds. Bryan also said strategies focused on growing dividends are likely to hold up better than those that target higher current yields.

There was also consensus that targeting stocks with economic moats is a winning strategy for dividend investors. Lefkovitz described moats as providing a cushion against dividend cuts since the rating allows investors to screen for companies that will be able to keep earning economic profits for years into the future. But everyone was careful to caution that investors can't target moats alone. Some very high quality firms don't pay out any dividends. Investors need to look at other factors like payout ratios, current yield, and financial health metrics to ensure the right balance between income and quality.

Tax reform is unlikely to have a major impact on dividend payers, according to the panel. Lower corporate rates are likely to move stock valuations up slightly (and in fact, Morningstar's models now assume rates will come down at least somewhat), but is unlikely to change the calculus around payout ratios or change behavior around buybacks.

Finally, the group addressed looking abroad for dividend stocks. Hodel and Bryan warned that although yields may look higher abroad today, non-U.S. firms are much more likely to cut payouts when times are tough as they target payout ratios and not dollar amounts. As earnings fall, so will the dividend. And there can be tax complications, too. Lefkovitz said there are lots of great businesses outside the U.S., that just as you want broad, global diversification for a general stock portfolio, it is worth exploring how to get some of that in your dividend portfolio, too.