For years, investors have gravitated to dividend-paying stocks as the best of all possible worlds. With the potential for price appreciation as well as reliable, predictable investment income, dividend stocks pulled in not just conservative investors looking to lock in gains from the bull market but also income investors who traditionally used bonds and other investments until their income dried up.
Now, though, the stock market has finally taken a turn downward, and dividend investors have noticed that many of their favorite names are taking losses they had hoped to avoid. Are dividend-paying stocks doomed to underperformance?
Which dividend stocks are getting hit hardest?
So far, we've seen some evidence that dividend-paying stocks are doing worse than the overall market since the latest pullback began. Going back to the end of April, the iShares DJ Select Dividend ETF (NYSEMKT:DVY), which has a high concentration of strong dividend payers, has fallen about 4%, compared to a more-or-less flat performance from the S&P 500 and other broader benchmarks.
By itself, a 4-percentage-point difference isn't really big enough to get excited about. But certain stocks that are favorites among dividend investors have seen much more extensive declines. Utilities are extremely sensitive to interest rates, and most stocks across the sector have declined. Even with natural-gas prices on the rise and thereby helping to make its fleet of nuclear power plants more attractive, Exelon (NYSE:EXC) has sunk 18% since the beginning of May. Yet even in the more conventional utility arena, giant Duke Energy (NYSE:DUK) has suffered a 12% drop, and other utilities have shared their double-digit percentage declines. For Exelon, Duke, and the rest of the industry, large levels of debt make them extremely vulnerable to future rate changes, and while interest expense won't rise immediately, it will slowly go up as the companies have to refinance maturing debt at higher rates.
Master limited partnerships are also facing pressure. Kinder Morgan Energy Partners (NYSE:KMP) has declined almost 10% in the past month, with investors wondering whether the MLP's yield will be sustainable in a higher-rate environment. Certainly, some of Kinder Morgan's decline stems from company-specific news, including its decision late last month to cancel a proposed $2 billion pipeline that would have run from Texas to California. But other MLPs have seen more modest declines.
Finally, mortgage REITs have taken substantial hits since the Federal Reserve signaled the return of higher rates. American Capital Agency (NASDAQ:AGNC) is down almost a third since the end of April, as shareholders prepare for what could be the end of favorable conditions for the mortgage-REIT industry and its high-leverage business model.
Why dividend stocks are falling
The key to understanding the pressure that dividend-paying stocks are seeing is to go back to what made investors buy them in the first place. For those who've understood the power of dividends all along, dividend stocks will remain a vital part of their overall portfolios, so they're unlikely to buy or sell based on short-term conditions.
But for those who bought dividend payers as substitutes for bonds, higher rates on fixed-income alternatives will entice them to return to bonds and sell off their dividend stocks. Consider: The average P/E on the iShares dividend ETF has risen to more than 19, implying an earnings yield of just over 5%. With a dividend yield of 3.6%, there's not much extra room for the ETF's underlying components to grow.
In the end, two scenarios could produce a dividend-stock decline. If rates keep rising, then bonds could recapture the attention of income investors, leading to a broad sell-off. Meanwhile, if growth stocks start to outperform mature dividend payers, then stock investors will chase that performance, selling off their dividend stocks and leading to potential declines in an asset-allocation shift.
Watch those dividends!
The crosscurrents in dividend-paying stocks will be interesting to watch for months to come, as the Federal Reserve starts to implement its promised new policies. With several scenarios that could produce further declines, be sure to watch your portfolio's risk level to make sure you're not overexposed to adverse conditions in the future.
Fool contributor Dan Caplinger owns shares of iShares DJ Select Dividend ETF. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.