Investors should also look to broaden their search for income beyond bonds. This suggests a greater emphasis on dividend-paying stocks, with an important caveat: Focus on dividend growth rather than the absolute level of yield. Many equity sectors offering high yields (such as utilities) are expensive and the most vulnerable to a rise in rates. Instead, yield-hungry investors can consider technology, financial, health care and select energy companies offering rising dividends.
Market Realist – As explained in the previous part of this series, long-term bond yields are likely to stay low even in a rising rate environment led by the Federal Reserve. In this scenario, investors could look to high-yield bonds (JNK) to earn higher income.
Yields for high yield bond funds are currently hovering around 6%, much higher than the Treasury yields of around 2%. However, remember that high-yield bond funds are risky assets. They don’t provide much diversification to your portfolios, since correlations between equities (SPY) (VTI) and high-yield bonds have been increasing over the past few years. The correlation coefficient was estimated to be as high as 0.73 from January 2010 to January 2015, according to BlackRock.
Investors should focus on dividend growth equities (IYLD) for alternative sources of income. Dividend-paying stocks can act as a cushion in this low-yield world, since they provide a steady source of income and also exhibit higher returns. The above graph from BlackRock shows how dividend growers and initiators have been registering more returns than dividend cutters and eliminators in the past.
Investors should avoid the utility (XLU) and telecom sectors. Even though they provide good dividend income, they are the most susceptible to rate-hiking cycles by the Fed. Investors should focus on the mature tech sector (IYW) (XLK). Not only does it have the scope for immense growth, but it also holds up well in rate-hiking cycles.
The tech sector also boasts low-leveraged balance sheets and cash stockpiles. The above graph shows the cash stockpiles held by top tech players like Apple (AAPL), Microsoft (MSFT), Intel (INTC), and Cisco (CSCO).
Read our series Where Dividend Investors Are Seeking Income to understand where you can find opportunities in equities.