What's long worked for dividend stocks no longer does as worries climb about interest rates

Markets Associated Press

Dividend investing used to be so easy, not to mention lucrative. But it may be set to get a lot different.

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Stocks that pay the biggest dividends took a nosedive last month. Power and gas utilities -- once such steady and boring payers of dividends that they were called "widow-and-orphan stocks" -- posted their second-biggest drop since the financial crisis. That's even though every other sector of the market continued to cruise higher in February.

Get ready for yet more swings, say managers of many dividend-focused mutual funds. Last month may have been a sneak preview of the volatility in store as interest rates eventually climb, and managers of dividend-focused funds have changed their playbook in anticipation.

To be sure, those same managers also still tout that dividend-paying companies tend to have more stable businesses and are profitable enough to promise regular checks to shareholders. Companies in the Standard & Poor's 500 index paid a record $45 billion in dividends last month, according to S&P Dow Jones Indices, and full-year payments look set for a fifth straight gain of at least 10 percent.

Even so, many fund managers are shying away from utilities and other very high-yielding dividend investments, the ones that worked best in prior years. Instead they're focusing on areas of the market that received less attention -- and fewer investment dollars -- but may better withstand rising rates.

The big price changes for dividend-paying stocks, up and down, are due to a simple cause: movements in interest rates. For years, bond yields have persisted at low levels, frustrating anyone looking for income. A 10-year Treasury note had a yield of 2.18 percent at the start of the year, roughly half of what it was a decade ago, for example.

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That pushed many income investors who typically would rely on bonds to pour into dividend-paying stocks with the highest yields.

Cue utility stocks, which have a dividend yield of 3.7 percent, well above the 2 percent yield of the S&P 500. When bond yields were falling, like last year, income-hungry investors piled into utility stocks and sent their prices surging. Utilities had a total return of 29 percent, easily topping other sectors and more than doubled the S&P 500's return.

But in February, the parade into utility stocks turned into a scramble for the exits. The yield on the 10-year Treasury rose to nearly 2 percent from 1.64 percent at the start of the month, and bonds suddenly looked more enticing. The rise in rates led to a drop in demand for utility stocks, sending them to a monthly loss of 7 percent.

Mariana Connolly, client portfolio manager for the JPMorgan Equity Income fund, calls investors who move from the bond market to stocks and back again "renters," as opposed to owners of dividend stocks.

She expects more renters to leave in the coming months as the Federal Reserve begins raising short-term interest rates for the first time since 2006. Their departure is likely to hurt the segments of the market with the highest dividend yields, she says.

That's a big reason why Connolly has been moving over the past 18 months from utilities, telecoms and real-estate investment trusts to areas of the market with lower yields, where renters are less prevalent.

She put money in financial stocks, for example. Not only do regional banks have fewer renters, rising rates could also enable them to charge higher interest rates on loans and increase their profits and ultimately their dividends.

And when the renters are all gone? "Once they go back to their day job as bond investors," Connolly says real-estate investment trusts and other high-yielding stocks will be available at more affordable prices.

Of course, predicting higher interest rates has been a notoriously common call along Wall Street for years. It's also been an incorrect one. Rates have remained stubbornly low.

Some contrarians expect interest rates to stay that way given how weak inflation is, particularly with the plunge in the price of crude oil. That could mean less pressure on the highest-yielding stocks.

David James, portfolio manager at the $4 billion James Balanced: Golden Rainbow fund, says the yield on the 10-year Treasury is more likely to fall in the next six months than rise, for example. He was buying some utility stocks last month.