With talk of slowing the Federal Reserve’s bond-buying program, treasury yields have started to rise. The yield on the 10-year treasury is now at a 52-week high after rising sharply in May, making fixed-income investments more attractive. Because rates have been so low since the financial crisis, investors have piled into high-yield dividend stocks in search of income. This has driven the price up and thus the yields down. On May 29 we saw many of these stocks dive in price as investors sold their positions as treasury rates hit their high.
Are all dividend stocks in danger from rising interest rates? Or are some safer than others?
Some stocks are like bonds
Many of the stocks hit hardest on May 29 were traditional dividend stocks held in countless retirement portfolios. These typically are large, high-quality companies with above-average dividend yields. Verizon Communications Inc. (NYSE:VZ), the telecom giant, fell by 2.5% on May 29 and has fallen about 9% from its high earlier in May. Verizon Communications Inc. (NYSE:VZ) is the kind of stock that people buy solely for the yield, and in the past a yield topping 6% was attainable.
If you notice in the graph above, right before the financial crisis hit, Verizon Communications Inc. (NYSE:VZ)’s yield was at just about 4%. Then, as all stocks fell in price, the yield shot up above 7%. But since the beginning of 2010 the yield has been constantly falling and has now reached a level similar to right before the financial crisis.
Investors have been buying stocks like Verizon Communications Inc. (NYSE:VZ) hand over fist because fixed-income investments have offered such low rates over the past few years. But all of this buying has pushed the yield down too far, making the stock unattractive. A 4% dividend yield may seem great, but in this case it’s not.
Why? Because dividend stocks have two components: yield and growth. Unlike bonds, which have fixed payments until they mature, dividend stocks have the capability to increase payments over time. But stocks like Verizon Communications Inc. (NYSE:VZ) will likely only grow the dividend at 2%-3% per year, so the yield needs to be extremely high for owning the stock to make any sense. Because of this, the stock will behave similarly to a bond in a rising interest rate environment – the price will fall.
I wouldn’t touch Verizon Communications Inc. (NYSE:VZ) stock unless it carried a yield of around 6%. If you own Verizon now, I would get rid of it. There are much better dividend options out there.