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Friday
Aug172012

How Rising Rates Make Dividend Stocks Less Attractive

The recent rotation out of defensive sectors has been especially painful for holders of high dividend paying stocks.  As we noted yesterday, the Utilities sector, which is generally considered the highest dividend paying sector in the market, is not only the sole sector currently not trading at overbought levels, it is also the only sector trading below its 50-day moving average!

So how come two weeks ago investors couldn't get enough of high dividend paying Utilities stocks, but now they want nothing to do with it.  The answer lies partly in the fact that as interest rates rise, dividend paying stocks become less attractive to what are considered safer alternatives.  Take the 10-year US Treasury, for example.  Three weeks ago, the 10-year had a yield of 1.38%.  At the time, more than 60% of the stocks in the S&P 500 had a higher yield than the 10-year.  Since that time, the yield on the 10-year has risen to 1.8%.  As a result of the rising yield on the 10-year, there are now 47 fewer stocks in the S&P 500 that yield more than the 10-year (266).  Furthermore, if the yield on the 10-year rises to 2%, less than half of the stocks in the index will have a higher yield.

The chart below highlights this trend and illustrates the fact that as interest rates rise, fewer stocks will look more attractive relative to Treasuries.  Granted, there are other factors that go into an investor's decision, but expected income from an investment is a large factor in the decision.  In the case of slow growth defensive stocks like Utilities, this takes on an even larger role.  While a Utilities stock with a yield of 1.75% may have had a 26% higher yield than a 10-Year Treasury three weeks ago, today it looks a lot less attractive with a payout that is 4% below the yield on the 10-Year.

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