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Market View

A focus on “bond proxy” sectors may cause investors to lose out on potential capital appreciation. We think a different strategy may be in order.

 

In Brief

  • News that the dividend yield on the S&P 500® index now exceeds the yield on 10-year U.S. Treasury notes has brought renewed attention to dividend-paying stocks.
  • However, we believe some popular dividend-investment vehicles lean too heavily on “bond proxies,” i.e., higher-yielding stocks from a narrow range of sectors with low growth, and therefore, less chance of stock-price appreciation.
  • Instead, we think investors may wish to consider a strategy that seeks to identify the most attractive dividend stocks from all sectors, potentially enabling them to benefit from dividend income and a greater chance of capital appreciation.

 

The dividend yield on the S&P 500® Index recently exceeded the yield on the 10-year U.S. Treasury note for the first time since January 2016 (see Chart 1). This uncommon occurrence serves as a reminder that with interest rates at ultra-low levels, dividend-paying equities may present an attractive alternative for income investors.

 

Chart 1. U.S. Dividend Yields Recently Exceeded 10-Year U.S. Treasury Yields
Difference between S&P 500 dividend yield and 10-year U.S. Treasury yield, September 22, 1989–September 30, 2019

Source: Bloomberg. Data as of September 30, 2019.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.
Past performance is not a reliable indicator or guarantee of future results.

 

Moreover, historically when the S&P 500 dividend yield overtook the 10-year U.S. Treasury yield, the subsequent 12-month return was positive with the exception of 2015. The average 12-month return over the five periods depicted in the table that accompanies Chart 1 was approximately 18%. This suggests that not only are dividend paying stocks attractive from an income standpoint, but also that equity markets have the potential for robust positive total returns in the coming year. 

However, we would note that not all dividend-focused strategies are the same. Equity income funds often have an overconcentration in sectors that pay a high dividend yield, but do not offer much potential for capital appreciation. The return profiles of these stocks have prompted investors to label them as “bond proxies.” These stocks are commonly found within the utilities, communications services (primarily telecom services), real estate, and consumer staples sectors. While bond proxy sectors are attractive in a low interest rate environment, performance is usually whipsawed when rates rise.

Investors considering a dividend-focused strategy should be wary of major sector biases. In fact, several major dividend income exchange-traded funds (ETFs) exhibit sector biases toward bond proxy sectors. As of October 2, 2019, two of the largest dividend ETFs, SPDR S&P Dividend ETF (SDY) and iShares Select Dividend ETF (DVY), were both overweight in bond proxy sectors relative to the S&P 500, based on FactSet data. The SPDR S&P Dividend ETF had an overweight allocation relative to the S&P 500 to the consumer staples and utilities sectors of approximately 8% and 7% respectively. Meanwhile, the iShares Select Dividend ETF maintained an overweight position relative to the S&P 500 in the utilities sector of roughly 23%.

While there are several large, dividend-paying companies within these bond proxy sectors, we think dividend investors should consider expanding their horizons. For, as Chart 2 shows, the universe of dividend-paying equities is quite broad.

 

Chart 2. Bond Proxies Represent Only One-Quarter of Dividend-Paying Stocks
Percentage of all dividend-paying stocks in the Russell 1000® Index from each sector, as of June 30, 2019

Source: FactSet. Data as of June 30, 2019. Aggregate total of sector representation reflects rounding of individual percentages. “Bond proxies” refer to sectors (in this case, Real Estate, Communication Services, Consumer Staples, and Utilities) containing mature, slow-growth companies that return a large portion of their earnings to shareholders when paying dividends, resulting in “bond-like” yields for investors.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment and are not intended to predict or depict future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

We believe this breadth can be put to work for investors. As we have noted in the past, a focus on just the highest dividend payers has exposed investors to more risk than they may have realized. Instead, we believe a better approach to accessing dividends may be for investors to utilize a diversified approach that focuses on uncovering the most attractive dividend payers wherever they can be found, thereby allowing their portfolios to potentially benefit from both the power of compound interest and the capital appreciation opportunity provided by higher-quality, undervalued dividend-paying stocks.

CLOSE-UP

“Bond Proxies” and Rising Rates
Since “bond proxies” are typically low- or no-growth stocks, their dividend payout is often a sizeable portion of their overall total return. So we think it would be no surprise that they tend to underperform when a spike in interest rates makes their dividend yields relatively less attractive. As the accompanying chart highlights, the classic bond proxy sectors were the relative laggards during the two most recent periods of rising rates: July 8, 2016–March 13, 2017, when the broader equity market (as represented by the S&P 500® Index) delivered a return of 13%; and September 7, 2017–November 8, 2018, when the market returned 16%.

“Bond Proxies” Have Underperformed During Periods of Rising Rates
Total return by S&P 500 sector during indicated periods when the yield on the 10-year U.S. Treasury note rose 100 basis points

July 8, 2016–March 13, 2017

September 7, 2017–November 8, 2018

Source: FactSet. “Bond proxies” refer to sectors (in this case, Real Estate, Communication Services, Consumer Staples, and Utilities) containing mature, slow-growth companies that return a large portion of their earnings to shareholders when paying dividends, resulting in “bond-like” dividend yields for investors.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. In September 2018 GICS changed the name of the Telecommunication Services sector to Communication Services.  In addition to the name change, certain companies that were previously included in the Technology and Consumer Discretionary sectors are now included in the Communication Services sector.
Past performance is not a reliable indicator or guarantee of future results.

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ABOUT THE AUTHOR

MULTI-SECTOR DIVIDEND INCOME
The Lord Abbett Affiliated Fund Class A invests primarily in dividend-paying stocks of large U.S. companies. Access performance and portfolio information.

MULTI-SECTOR DIVIDEND INCOME
 

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