As many people focus on the race to replace Ben Bernanke as Fed Chair, we shouldn’t forget that he hasn’t gone yet, nor are we likely to see any immediate, significant policy changes when he does. The position is a powerful one, but ultimately decisions are made by a committee and the course for the next few quarters seems fairly well set. At some point, probably before the end of the year, the Federal Reserve will start to gradually reduce the amount of Treasuries and Mortgage Backed Securities (MBS) it buys each month; the much heralded “tapering” will begin.
In anticipation of this, interest rates on those instruments have begun to rise. (The relationship is simple. The Treasuries and MBS pay a fixed amount of interest each month. If demand for them is reduced by the Fed reducing the amount they buy, then the interest you receive on the purchase price goes up. If a bond pays 10% on an issue price of $100, it pays $10 per year regardless of how much you pay for it. If the price falls to $90, then your $10/year represents a yield of 11.1%. The drop in price has resulted in higher rates.) A side effect of this has been some pressure on dividend paying stocks. Their return has become less competitive and less desirable as interest rates generally have edged upward.
Dividend stocks have been all the rage for the last couple of years, for obvious reasons. When the 10 Year T-Note is paying less than 2% interest, taking a 2.5-3% yield from a stock with the potential to increase in price is attractive. Many people invested in portfolios designed to take advantage of that, often combining solid companies that pay a slightly above average dividend with some more risky, higher paying stocks in order to “juice” the overall yield.
The problem with that strategy became clear on May 22nd, when Bernanke first started talking about tapering. Dividend payers, especially those with high yields, got crushed when the prospect of a higher interest rate environment emerged. Master Limited Partnerships (MLPs) such as Mark West Energy (MWE) ably demonstrate the point. MWE and other MLPs don’t pay interest as such, they distribute nearly all profit to shareholders. They are, in effect, a dividend payer on steroids.
The high on the MWE chart was achieved on May 22nd and the stock dropped around 15% in the following month before recovering somewhat in the last few weeks. Other high yielding stock has followed the same pattern.
Chimera Investment (CIM) is a mortgage REIT. This stock also dropped around 15% in the month following Bernanke’s announcement. Once again, it has since bounced back somewhat.
If you did add these or similar high yielding stocks to your portfolio in order to bump up overall yield, you should consider using this bounce back to sell them. The initial move down was on the possibility of something. When that something actually happens, and most believe it will, the drop is likely to be repeated. Add to this the possibility that the dividend paid could be cut and it is hard to escape the feeling that, for now at least, high yielding instruments such as mortgage REITs and MLPs are best left alone.
The higher quality dividend payers that you own, however, should be held on to. I wrote yesterday about the possibility of a stock market correction in the next few weeks and, should that be the case, high quality dividend paying stocks are likely to outperform most categories. Many have written of the value of companies with a history of growing their dividend. I agree; not only does this give an indication of a solid, growing company, it also protects the percentage yield against inflation.
Old faithfuls such as Exxon Mobil (XOM), General Electric (GE) and Procter and Gamble (PG) may not be sexy, but yields of 2.69, 3.1 and 3.0 percent respectively are decent given the safety of the company, even in a world of rising rates. XOM also has a dividend growth rate of 13%, according to VectorVest, with GE and PG no slouches either at 8% and 12%. Even after inflation, this results in increased income each year.
The idea of “risk on, risk off” has become familiar to most investors as a trading strategy and style. It is worth remembering, however, that any portfolio, even one designed to be fairly conservative and that targets yield, should be occasionally adjusted on the basis of risk. In general, return on investments is reward for risk. This is certainly true of the higher yielding stocks you may own, but, by focusing on established dividend growth companies, it is possible to get a reward while actually reducing risk.