With rising rates and disappointing fixed income, this strategy could prove useful

April 20, 2022

In a rising interest rate environment, investors are reconsidering their exposure to fixed income securities, changing allocations or, in some cases, exiting the asset class entirely.

Michael Hunstad, head of quantitative strategies at Northern Trust, postulates that adding exposure to dividend-paying stocks to a portfolio could help investors manage risk without losing return.

“When I think of high-dividend-yielding stocks, they tend to be value-oriented,” Hunstad said over the phone. “Bonds trade at higher margins. Dividend stocks are a very good source of yield, a good use of risk, and you’re not buying into the most expensive part of the market.

Hunstad tests this hypothesis in a single market environment. The Federal Reserve had kept interest rates low for years, but that changed in 2022 when it became clear that inflation was not going to be transitory, as the central bank had predicted.

The Fed raised rates by 0.25% in March and is expected to raise them again later this year. Northern Trust’s view is that there will be two 50 basis point interest rate hikes before the end of 2022. This view is more conservative than some of the firm’s peers, but Hunstad has said he thinks the Federal Reserve will have to find a balance. between managing inflation and not “scaring the market”.

When interest rates rise, the value of bonds tends to fall. The fixed income asset class is already struggling to meet investors’ expectations, often forcing them to seek yield in safe havens outside of traditional bond markets, including private credit.

Hunstad thinks dividend-paying stocks could be another safe haven for investors. He said that in each of the last five rate hike cycles, dividend-paying stocks have outperformed the broader market by an average of more than 12% over the entire cycle. Hunstad expects dividend strategies to return between 2% and 4% for investors, with room to maneuver if interest rates continue to rise.

In markets where interest rates are rising, he added, value strategies — which often include dividend-paying stocks — tend to outperform growth-based strategies. “An engine of growth [underperformance] is the rise in interest rates,” Hunstad said. “These growth stocks have a lot of future earnings that they discount today based on interest rates…Given we’ve just started the rate hike cycle, I think growth will struggle. ”

A recession could also put more pressure on growth stocks than on their value counterparts. “If the economy goes into a recession, stock prices are likely to drop,” Hunstad said. “Which go down the most? Those who are the most expensive. »