Written by Ben Carlson
One of the biggest fears investors have right now, is that interest rates will rise substantially from their current historically low levels. Many believe this inevitable interest rate increase could lead to the underperformance of dividend paying stocks.
Bonds are directly impacted by an increase in rates, but other income producing investments such as REITs, preferred stocks and dividend stocks could also be adversely affected. See my previous post - The Risks of High Yielding Investments.
Since bond yields have been so low for so long now, dividend stocks have enjoyed a strong rise and have probably attracted many yield hungry investors. This has the potential to push up the prices on some of these dividend stocks to overvalued levels. This could be what we are currently seeing happening to U.S. dividend stocks. This is a topic I covered in more detail, in Are U.S. Dividend Stocks Overpriced?
According to Mebane Faber of Cambria Investment Management, the U.S. stock market is the most expensive stock market in the world by one valuation method.
This means investors who have the majority of their capital in U.S. dividend stocks, could be hit in a rising rate environment, at the same time that these stocks are becoming overvalued.
So how should you proceed?
It’s impossible to predict the timing and extent of a rise in interest rates. However, you can prepare yourself by looking at past cycles of rising interest rates, to see which dividend stocks performed the best.
O’Shaughnessy Asset Management (PDF file) recently released a report detailing their thoughts and research on the impact of rising interest rates on dividend paying stocks.
Since the late 1920s there have been sixteen periods when the 10-year U.S. Treasury yield increased by more than one percent in a twelve month time frame. Rate increases of that magnitude in such a short time frame are what worry investors.
O’Shaughnessy found that during these past rising interest rate environments, U.S. dividend stocks have underperformed the stock market as a whole while global dividend stocks have outperformed their U.S. counterparts.
They also found that dividend paying stocks outside of the U.S. are currently trading at valuation levels almost 25% cheaper than those in the U.S.
So if you are looking for places to reinvest your income or capital gains from U.S. dividend stocks, or are worried about a potential rise in interest rates, you should think globally.
Not only are dividend stocks outside of the U.S. trading at lower valuations, but they offer substantially higher yields.
Blackrock recently put out this chart that shows the yield differential between U.S. and international stock markets:
Canadian, European and Emerging Market companies, all sport higher than average dividend yields as compared to U.S. companies. Investing globally also gives you the added benefit of diversification, if you are heavily weighted towards the U.S. markets in your portfolio.
Thus, looking for dividend paying stocks outside of the U.S. means higher yields at lower valuations.