Since bottoming out in 2020, interest rates have mostly risen amid higher inflation, with signals that the Federal Reserve will further raise rates multiple times in 2022. This can pose two challenges to stock investors: maintaining the kind of steady income you'd get from bonds, and keeping higher rates from eroding companies' stock prices and values. But a single class of investment might help you solve both those problems – provided you know how to find the right offerings.
Dividend-yielding funds invest in companies that pay cash dividends, which can help them provide a steady source of income and return in the face of inflation. That's especially true if and when companies choose to increase their payouts. According to S&P Dow Jones Indices, more than 2,900 US companies initiated or increased their dividends in 2021, a 53% increase over 2020.
How dividends boost investment returns
There are two parts to a stock's return: how its price changes over time, and the dividends it pays. A study by Fidelity found that dividends provided 40% of the stock market's historical return.
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When companies don't pay dividends, the degree to which their prices rise or fall depends more heavily on how investors convert their future profits into today's dollars, using what's known as a discount factor. Falling interest rates and lower inflation mean a company's future dollars will lose less of their buying power between now and then. So investors are willing to give those far-off earnings greater weight – a lower discount factor – in determining what they're willing to pay for the stock right now. But when rates rise and the value of future profits shrinks, the discount factor goes up, and the stock's price tends to go down.
The steady payments dividends provide can help stocks preserve their present-day value in investors' eyes, even when future earnings seem less certain or valuable. So when rates rise, investors tend to move toward the stability of dividend payers.
When we add up every week over the past 12 months where the 10-year Treasury yield rose more than 5 basis points – that's five one-hundredths of a percentage point – the Vanguard High Dividend Yield ETF's (VYM -0.29%) returns in that period beat those of the S&P 500 by 9%, according to Bloomberg data. In the same period, Amazon.com Inc (AMZN -1.65%), which pays no dividends, and whose growth is therefore more sensitive to higher rates, lagged the S&P 500 by 19%.
What to look for in dividend funds
Dividend-yielding funds may have different rules for including dividend paying companies in their portfolios. The SPDR Dividend Yield ETF (SDY -0.43%) includes companies that have historically increased their dividend for 20 consecutive years. The Vanguard High Dividend Yield ETF includes stocks that currently pay a dividend. Both funds are well-diversified, with 100-400 holdings each. That sheer size helps them represent a broader swath of the market while reducing the volatility that any one stock might bring.
With inflation and interest rates both rising, dividend-yielding ETFs have the potential to provide regular income while also adding to returns. Just remember that certain dividend-paying funds may have higher-than-average dividend yields because the stocks in their portfolio have fallen in price -- making their payouts look bigger, proportionally -- and therefore may be at risk of cutting or suspending their dividends. Yields for most dividend funds currently fall in the 2%-4% range. Any payouts much higher than that may signal that the fund's selling off stocks that are failing to meet its criteria, or that its future dividend payouts may be at risk.
