U.S. Markets open in 5 hrs 25 mins

High-Yield Dividend ETFs Fall Out of Favor in Rising Rate Environment


Investors may want to reduce exposure to high-yield dividend exchange traded funds in a rising interest rate environment.

The Dow Jones U.S. Select Dividend Index, which includes 100 stocks screened for dividend growth and weighted by annual yield, has underperformed the S&P 500 Index by 4.5% since April 30, 2013, as yields on the benchmark 10-year Treasuries have increased to 2.65% from 1.67%, Bloomberg reports.

The iShares Select Dividend ETF (DVY) , which tracks the Dow Jones U.S. Select Dividend Index, has gained 10.4% since April 30, compared to the S&P 500 Index’s increase of 15.5%. [Inflation Fighting With Dividend Growth ETFs]

Over the years, dividend stocks and related funds, like DVY, have attracted investment interest as a “bond substitute” that provide higher yields than fixed-income assets, but the trend is starting to reverse as interest rates rise and bond prices fall, according to Jack Ablin, chief investment officer at BMO Private Bank.

“If the U.S. economy stays on the path it’s on, 10-year Treasury rates could hit 4 percent this year, pushing these stocks further out of favor,” Ablin added.

According to economists’ median forecasts, yields on benchmark 10-year Treasuries could rise to 2.35% by the end of the year while GDP expands to 3% by the end of 2014 from 1.9% in the first quarter.

Jeff Mortimer, director of investment strategy for BNY Mellon Wealth Management, believes that high paying dividend stocks will track closely with 10-year Treasuries.

“Stocks that have a bond-like component will be weighed down by rising interest rates,” Mortimer said in the article.

Jim Stellakis, founder and director of research at Technical Alpha Inc., points out that high-yield stocks have been trading in a “series of declining peaks” relative to the market.

“These lower highs show investors want progressively less and less exposure to high-dividend paying companies,” Stellakis argued.

Mortimer, though, does not suggests exiting out of high-yield stocks completely. Instead, he believes investors should pair high-dividend paying stocks with high-growth stocks, like technology, health care or biotechnology, that don’t have high cash payouts.

For instance, the Technology Select Sector SPDR (XLK) increased 15.9% since April 30. Meanwhile, the Health Care Select Sector SPDR (XLV) is up 23.9% and the iShares Nasdaq Biotechnology ETF (IBB) has gained 48.1%. [Health Care Heaven: Sector’s ETFs Flex Their Muscles]

For more information on dividend stocks, visit our dividend ETFs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.