With interest rates rising in 2013 and after a number of years of outperformance from high-yield dividend paying equities, investors want to know if dividend investing remains an attractive strategy. With corporate balance sheets looking healthy and dividend payout ratios remaining low by historical standards, we believe dividend growth will continue to be strong. In our view, high-yielding equities will continue to provide strong total returns especially relative to fixed income alternatives.

U.S. equity markets rose more than 30% in 2013 as investors anticipated accelerating corporate earnings. For the year, S&P 500 operating earnings rose by 10.8% with P/E multiple expansion accounting for the rest of the market’s rise. One result of this move is that the market’s dividend yield declined from over 2.5% to just under 2% currently. At the same time, U.S. Treasury rates (as measured by 10-yr bonds) rose by 1.25% to end the year at 3% reversing what had been a relatively unique phenomenon—yields on equities that exceeded longer-term government bond yields. 

Uncertainty about the Federal Reserve’s quantitative easing policies and potential acceleration of the U.S. economy fueled both rising rates and rate volatility last year. When combined with the reversal in equity market yield premiums relative to bonds, higher-yielding equities underperformed the market causing some to question whether the strong performance of higher-yielding equities has come to an end. We don’t believe so. It’s our expectation that the recently high correlation between interest rates and high-yield equities will revert back to longer-run levels. The interest-rate sensitivity of the highest yielding quintile of the market has been at levels above even the peaks seen in the last 85 years (Exhibit 1). 

Exhibit 1

A major reason for the elevated interest rate sensitivity of high-yield equities has been the Fed policies which drove down bond yields resulting in the premium to yields from equities. Even if rates continue a long-term increase from current levels, we expect that equities sensitivity to rising rates will decline. This has occurred before, such as during the period from 1948-1960 when rates nearly doubled to 4%.

With rising rates not expected to be a barrier to strong performance of high dividend equities, what about the prospects for dividend growth? The potential of stock dividends to grow with earnings provides a meaningful benefit when using high-yielding equities as a source of income in a portfolio. Unlike bonds where income is fixed, stock dividends can provide a measure of inflation protection. In the three years ending last year, market earnings have grown by nearly 9% per annum but market dividends have climbed by over 17%. The payout ratio for the S&P 500 has risen only slightly to 33% up 6 points from its low in 2011 and it remains well below the long-term average of 64% (Exhibit2).

Exhibit 2

Source: Standard and Poor’s

Wall Street strategists currently forecast an 11% increase in both market earnings and in dividends for 2014 and no increase in payout ratios. Corporate balance sheets remain strong with high average cash balances and moderate leverage. With last year’s expansion of valuation multiples, share buybacks, an alternative form of capital return to shareholders, are relatively less attractive than dividend increases at the margin. In our opinion these factors support strong dividend growth in the next few years.

We believe the drivers that have resulted in historical stock market outperformance from high-yielding equities remain intact. Briefly, valuations of high-yielding stocks benefit from the capital discipline dividends impose on management, dividends enjoy favorable tax treatment relative to interest income and growth in dividends can provide a measure of inflation protection for portfolio income. We believe the current environment remains very favorable for high-yielding stocks for two reasons; 1) the expected decline in interest-rate sensitivity which contributed meaningfully to the underperformance of these stocks, and 2) the likelihood that healthy corporate balance sheets and earnings growth can fuel strong dividend growth in the future. When considered in total, we believe a diversified portfolio of high-yielding equities (or a mutual fund focused on higher-yielding stocks) continues to provide a compelling source of investment income relative to other alternatives.

Disclosure 

The views expressed are as of 5/12/14, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.

This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time and issuers may reduce or eliminate dividends paid on securities in the event of a recession or adverse event affecting a specific industry or issuer.

The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.

It is not possible to invest directly in an index.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.

Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC.

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