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Income Investing

The Fed Ends Quantitative Easing: What’s Next for Dividend Stocks?

By Roger S. Conrad on Nov. 4, 2014

Last week, the US Federal Reserve ended the third edition of its quantitative easing, a program whereby the central bank purchased bonds in the open market to drive down long-term interest rates.

And with short-term interest rates still hovering around zero percent, conventional wisdom suggests that the central bank’s next move will be to raise rates, triggering an automatic devaluation of bonds and dividend-paying stocks.

Don’t believe the hype.

For one, this simple logic led all too many investors to throw in the towel on perfectly good stocks in early 2014—and miss out on what has been a banner year for many dividend payers.

The Dow Jones Utilities Average, for example, has gained more than 25 percent this year, while the Bloomberg North American REIT Index has also rebounded from a decline in the back half of 2013 to post a 25 percent gain in 2014.

Investors shouldn’t lump dividend-paying stocks in the same category as bonds by assuming that rising interest rates are a death knell.

Popular dividend-paying equities historically have exhibit scant correlation to changes in interest rates.

Since its inception in 1996, the Alerian MLP index has rallied in eight of the 11 years that the 10-year Treasury note’s yield has fallen, including 2014.

But the index of 50 popular master limited partnerships (MLP) has also posted a gain in six of the seven years when the yield on the 10-year Treasury bond increased.

MLPs are structured to pay generous distributions. But as stocks, their market prices reflect the strength of the economy and industry-specific trends—namely, growing demand for energy infrastructure to support surging US oil and gas production.

And as our graph demonstrates, this logic applies to other popular dividend-paying stocks.

(Click graph to enlarge.)
Dividend Stocks vs Interest Rates

For instance, the Dow Jones Utilities Average has rallied in nine of the 12 years since 1993 that interest rates have declined. However, in the other three years, this basket of utility stocks has suffered an average loss of almost 26 percent.

And the utility sector’s only significant loss when interest rates increased occurred in 1994, when the Dow Jones Utilities Average gave 15.5 percent of its value amid the shock of deregulation. In fact, this basket of utility stocks has eked out a gain in seven of the nine years when interest rates ticked up.

The pundits who continue to spew the conventional wisdom about dividend-paying stocks and interest rates conveniently ignore these facts.

Weaker hands that buy into this market have lost money; the returns generated by MLPs, utility stocks and real estate investment trusts (REIT) ultimately track trends in the broader stock market.

Interest rates have been important insofar as they influence economic activity and trip up overleveraged companies that face challenging fundamentals in their underlying businesses.

Much of the success in our Conservative Income Portfolio and Aggressive Income Portfolio has come from stock selection, a focus on valuation and taking big profits off the table in some of our faster moving holdings.

CUI-Evergreen

Fed Focus

When former Fed Chairman Ben Bernanke unveiled plans to scale back quantitative easing in spring 2013, dividend-paying stocks sold off indiscriminately and sent the yield on the 10-year Treasury note soaring to more than 3 percent from barely 1.6 percent.

However, the market’s reaction to the actual end of quantitative easing has been decidedly muted; investors had already come to grips with this eventuality. Although the 10-year Treasury note’s yield has ticked up slightly since mid-September, the current yield of about 2.3 percent remains relatively low.

What the Fed’s next move will be is open to debate.

Some economic data points have improved to their strongest levels since before the 2008 crash. For example, the unemployment rate has shrunk to 5.9 percent, and US gross domestic product grew at an annual rate of 4.6 percent in the second quarter.

On the other hand, US households’ median inflation-adjusted income has dropped by 3 percent from the nadir of the Great Recession, while concerns about slowing economic growth in the EU and China have also emerged.

Rising interest rates would exacerbate the decline in household incomes and boost the value of the US dollar, undermining the competitiveness of American exports.

Nor does subdued US inflation (1.8 percent in 2014) justify raising interest rates, especially with Europe facing an elevated risk of deflation.

Until we see an improvement in household incomes, the Fed will face political pressure to keep monetary policy accommodative for longer than in previous recoveries.

What about Bonds?

All these factors add up to a sellers’ market for bonds.

Over the past five years or so, virtually any company or government entity with an investment-grade credit rating has pushed out the average maturities of its debt structure while reducing interest expense.

Regardless of the Fed’s quantitative easing, many pension funds and other institutional investors have mandatory allocations to fixed-income securities and must buy whatever the market has for sale.

In this environment, Enterprise Products Partners LP’s (NYSE: EPD) 7.034 percent bonds maturing Jan. 15, 2068, offer a yield of 3.336 percent. And Wisconsin Energy Corp’s (NYSE: WEC) 6.875 percent bonds maturing Dec. 1, 2095—that’s 81 years in the future—yield only 5.161 percent.

Low corporate borrowing rates have underpinned the economic expansion and the bull market for stocks that began in March 2009. And the Fed is unlikely to do anything to undermine that foundation until the economy really breaks out.

The 10-year Treasury note will continue to bounce around with the latest speculation about Fed policy—that’s the basic function of such a liquid security. However, those betting on a meltdown in the bond market will need to content themselves with trading the occasional flare-up in investors’ fears.

These days, finding a decent yield in the bond market entails moving down the credit ladder or purchasing issues with longer-dated maturities.

Closed-end bond funds find themselves between a rock and a hard place, with prevailing interest rates forcing them to accept lower coupons when replacing maturing or called issues. Elevated leverage makes most of these investment vehicles ticking time bombs.

However, the Oct. 8 issue of Capitalist Times Premium identified one high-yielding bond fund that could be worth aggressive investors’ while.

The Verdict

Dividend-paying stocks backed by healthy, growing companies are the best places for income-seeking investors to put their hard-earned money. This approach ensures that your cash flow keeps up with inflationary pressures and results in capital appreciation.

With few exceptions, a rising dividend is the best indicator of a company’s underlying health.

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ABOUT ROGER CONRAD

Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b