In A Rising Rate Environment, Does Dividend Growth Still Make Sense?

This is the question on every income investor’s mind. After a five-month start to the year in which income-focused investments went nearly parabolic, concerns that the Fed might—just might—start winding down its quantitative easing sent the share prices of REITs, MLPs, utilities, and other popular investments into a tailspin.

The JP Morgan Alerian MLP ETN (AMJ) and the Vanguard REIT ETF (VNQ)—both holdings in the Strategic Growth Allocation—dropped by 6% and 10%, respectively, from their May 21 highs through June 4, at time of writing.

Some of Sizemore Capital’s favorite income securities held in the Dividend Growth Portfolio—such as Realty Income (O), National Retail Properties (NNN), and Martin Midstream (MMLP) were down by 20%, 17%, and 10%, respectively.

After dramatic reversals like these, it’s easy to panic. But let’s put them in perspective. Even after the May bloodletting, all of these securities are positive for the year, and after including dividends all are up by over 10%. The price correction we saw was simply a shakeout. The hot money had run the prices of these securities up, and when the hot money abandoned them they simply wiped away the speculative froth.

Interestingly, REITs and utilities took a harder hit than MLPs. Though I have no hard evidence to support this, my theory as to why this happened was that MLPs tend to have greater ownership by individual income investors and tend to be less affected by the hot money’s changing moods.

So, back to the original question, what now? In an environment of rising rates, does a dividend growth strategy still make sense?

It does, but only if you do it right. Sizemore Capital has very little exposure to bonds and no exposure at all to slow-growth income investments such as utilities. In this environment—and in any environment of non-zero inflation—future dividend growth is more important than the current payout.

This is why we are overweight in the sectors with what we consider the right mix of decent current income and excellent potential growth in income—sectors such as retail REITs, mid-stream MLPs, and “Big Tech” companies such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO).

And to be clear, I am by no means certain that the rise in interest rates will go much higher than it already has in the near term. As the experience of Japan proved, market yields can stay low for much longer than anyone expects during a prolonged period of debt deflation and aging demographics.

But to the extent that rates do rise, you want to own assets that stand to benefit from an improving economy and that have room to raise their cash payouts at a rate that will keep pace with rising market yields. On this count, midstream pipeline MLPs and most categories of REITs easily qualify. Rising interest rates raise their borrowing costs and cut growth prospects at the margin. And because these securities have become bond substitutes of late, falling bond prices (i.e. rising yields) mean falling stock prices.

But given that the 10-year Treasury still only yields 2.1%, a 4%+ dividend yield an a high-quality real estate and infrastructure portfolio still makes them vastly superior investments for income investors. The dividend payout can be expected to grow over time with only modest risk of loss, whereas Treasuries are only “risk free” if you ignore inflation.

We may see more turbulence in dividend-focused investments as institutional investors rotate into more aggressive sectors. I’m ok with that, and I intend to use any further weakness as a buying opportunity.

Disclosures: All securities mentioned are held in Sizemore Capital portfolios.