Over the last few months the market has experienced great volatility. Headlines surrounding the Federal Reserve's monetary-policy actions haves caused investors and traders alike to question their asset allocations. After years of falling interest rates, bonds caught a bid as fears of tightening monetary policy quickly surfaced. The entire yield curve experienced a shift to the upside at the thought of rising interest rates and "tapering."
The closely watched 10-year Treasury bond saw its yield soar from less than 1.75% back in May to more than 2.75% in a matter of months. While some investors may question the significance of a 100-basis-point move considering historical yield levels, some consumer groups have started to push back slightly. However, over the last couple of days we have begun to see interest rates fall back from their highs.
As most readers may know, Lawrence Summers has withdrawn from the race to become the next chairman of the Federal Reserve Chairman. Summers' abrupt decision bolstered risk appetite, as investors had expected Summers to take a more hawkish position regarding stimulus than other candidates. Now Fed Vice Chairman Janet Yellen has taken the position of front-runner for Ben Bernanke's job. Yellen would be expected to continue Bernanke's lax monetary course; the two largely see eye to eye on many decisions. Should Yellen be confirmed, it is plausible that interest rates will give back even more over their gains.
Let's take a look at a few equity vehicles that stand to benefit from falling interest rates. Falling interest rates increase the demand for-high yielding dividend equities. It's simple economics: If the spread between Treasury bonds and dividend yields widens, the added benefit of owning equities versus bonds increases. Therefore demand (the price) for high-yield equities should increase as rates fall.
Utility space
Long-term investors often allocate a portion of their portfolio to the utilities sectors. After all, high dividend payouts, consistency, and economic stability are the keys to investing. Over the last quarter the Utilities Select Sector SPDR Fund (XLU 0.67%) has greatly underperformed the broad market. Shares of the widely recognized utility fund are down by more than 1% over the last three months. The fund provides strong exposure to the space, as the name would suggest. Its top three holdings -- Duke Energy, Southern Comany, and NextEra Energy -- are all represented with weightings of more than 7% within the fund.
As I suggested in the introduction, falling interest rates will increase the attractiveness of the utilities sector. By going with the Select Sector fund, you can easily diversify to further mitigate portfolio risk. With a gross expense ratio of only 0.18%, investors don't have to worry about paying excessive fees for exposure.
One utilities company I like in particular is Aqua America (WTR 1.05%), a beaten-down water utilities company with exposure in the eastern half of the United States. Aqua America has sought to bring together a fragmented water utilities industry through an active-acquisition strategy. With more than 200 acquisitions over the last decades, the company has been able to steadily drive earnings per share higher quarter after quarter. With government agencies raising the bar on water quality standards, only the large water utilities companies have the capital to comply on hand. Thus the smaller competition is often forced to give in to larger counterparts. Through these acquisitions, Aqua America improves its operating efficiency and moves closer to its minimum efficient scale -- i.e., or the smallest output that a firm can produce such that its long-run average costs are minimized. Shares have fallen more than 12% from their 52-week highs, and as a result the company now pays a respectable 2.5% dividend yield.
Broad high-yield exposure
For longer-term investors who want broader exposure to the high-dividend equity space, I would suggest they check out the Vanguard High Dividend Yield ETF (VYM 0.26%). Like many Vanguard funds, the VYM has an exceptionally low expense ratio of only 0.1% while offering a great yield of 3%. Within the top 10 holdings are a number of solid and familiar names perfect for the long-term portfolio. Included are Wells Fargo, ExxonMobil, Johnson & Johnson, and General Electric. These companies all offer investors great exposure to the long side of the market while being known for their long history of increasing dividends. I believe we will see increased inflows into this fund as the Street looks to reallocate capital from the fixed-income market. As the value of this fund rises, I remain confident that the pace of increasing dividends will keep this yield supported at 3%.
Wrap-up
Should interest rates fall back toward the lows seen earlier this year, I would expect equities with strong dividend payouts to benefit. As interest rates fall, simple economics says the demand for the additional yield will rise.
