Revisiting Dividend Growth Stocks: Why They Still Matter in a High Rate Environment

Before the Federal Reserve’s recent rate hike scheme, income investors were forced to look outside the box for yield — often, the path to higher income took them into dividend stocks. But with yields reaching levels not seen since 2002, bonds and even cash have quickly become the only destinations for investors looking for income to tread. Dividend stocks have fallen flat.

However, investors may not want to give up their dividend-paying equities just yet.

It turns out that dividend growth can be a powerful tool in a high rate environment such as today. More importantly, even if the Fed cuts rates, the days of zero interest rate policy (ZIRP) rates are long gone. This provides a powerful edge to dividend stocks and their payout growth. For investors, it may be time to turn their attention back to dividend equities.

The Federal Reserve policy has impacted a lot of different areas of the market and sectors of the economy. One of the most affected by the rate hikes has been dividend-paying equities.

Back in the days of zero percent interest, traditional income products and asset classes like bonds, CDs, money markets and T-bills paid basically nothing. If you wanted to get more than the 0.01% on your savings account or 1.5% in a 10-year bond, you needed to look elsewhere. Much of that investor interest was squarely set on dividend stocks.

However, as the Fed raised rates, these safer and traditional income products started paying real cash once again. For dividend-paying equities, this was the death knell. Why take the risk when you can get a guaranteed 5%+ in T-bills or cash? And if you are going to take the risk, tech and the growth of A.I. seem like better bets for higher returns.

As such, the broader dividend sector has underperformed over the last year or so. Year-to-date, the S&P U.S. Dividend Growers Index — as represented by the Vanguard Dividend Appreciation ETF — is only up about 8%. While that’s not a bad return, it doesn’t compare to the 22% gain for the broader S&P 500.

Going back further, dividend growth — and high-yielding dividend stocks for that matter — have really suffered versus the broader index. Just take a look at the below chart comparing the S&P 500, dividend growth, and high-yielding dividend stocks from the summer of 2022, when the Fed first started raising rates, till now.

Source: Stockcharts.com

You can clearly see the S&P 500 (blue line) take off as investors have moved to risk and those looking for income fled to safety in bonds.

Despite the underperformance, investors may not want to get rid of dividend growth stocks just yet. It turns out that the current environment may be a perfect one for those firms that steadily raise their payouts.

For one thing, the payouts themselves are the draw. Unless you buy floating rate debt, a bond’s payouts are static. When you buy it, you lock in the coupon and yield. This becomes a problem with inflation. While inflation has moderated, analysts now predict that we’ll see a return to the norm of inflation in the 2 to 3% long term. Bond investors — aside from those in TIPS — are stuck in that regard as their payouts don’t rise with inflation. However, the long-term dividend growth rate for the S&P 500 has averaged about 6.64% since the 1990s, which more than beats the rate of inflation.

Another thing to remember is that while the Fed is expected to cut rates, the years of ZIRP are most certainly never to return. The Fed’s so-called neutral rate is almost guaranteed to be higher. According to asset manager Lord Abbett, this becomes an issue with regard to separating the wheat from the chaff in terms of stock performance. Higher interest rates make it harder for firms to borrow. That’s a big deal for firms only relying on growth and revenues for their stock performance. Firms that can self-fund via profits and cash flows will naturally be able to rise to the top. And we’ve already begun to see that trend.

Looking at the years 2021-2023, Lord Abbett’s data shows that profitable, high-quality companies managed to outperform their unprofitable rivals by a whopping 21%. One of the hallmarks of quality and profitability remains significant free cash flow generation that translates into dividend growth. When interest rates were low, the outperformance of profitable companies versus non-profitable ones was only 4.4%. ¹

Then there is valuation to consider. Dividend growth stocks as a whole are some of the cheapest out there. When looking at forward price-to-earnings ratios, non-dividend-paying companies are trading above their 10-year average relative to the S&P 500. Conversely, dividend growth companies are trading below their 10-year average. This makes sense as investors have flooded A.I.-related stocks, high-growth tech names, and healthcare stocks, among others.

For investors, the ability of dividend growth stocks to offer a yield that increases beyond the rate of inflation is a top-notch reason to not throw them away for bonds and cash. Ultimately, those growing payouts will hold their value as rates normalize but remain high. The same could be said for rates of inflation over the long haul. Meanwhile, the premium placed on firms that can self-fund and provide real earnings will only grow as rates (and borrowing costs) stay high.

ETFs make an easy choice for adding dividend stocks to a portfolio. There are numerous active and passive funds out there that can be used to add a touch of dividends to a portfolio.

These funds are selected based on their dividend yields, which range between 1.7% to 3%. They are sorted by their YTD total return, which ranges from -1.6% to 16.5%. Their expense ratio ranges from 0.06% to 0.35%, while their AUM is between $2.8B and $84B.

Another choice for investors is to go individual with your dividend holdings. There are numerous ways to build a portfolio of independent dividend-paying stocks. Our screeners here at Dividend.com can reveal some top names across various sectors. At the same time, our premium lists and model portfolios allow you to customize your dividend investing style

These stocks are selected based on their dividend yields, which range from 0.64% to 4.55%. They are sorted by their YTD total return, which ranges from -15% to 35%. They have market capitalization between $11.7B and $3,425B, and they have grown their dividends between 5 and 69 consecutive years.

Overall, dividend growth stocks still have a lot of appeal for investors. The ability to provide an inflation-beating yield over time is a major win in the new high rate/high inflation environment. With that, investors shouldn’t be so flippant to cast them away — better returns could be on the horizon.

As bonds have yielded more, dividend growth strategies have sunk. But that doesn’t mean investors should cast them away — it’s quite the opposite. Their rising dividend payments will be big winners for income seekers in the new market regime.

¹ Lord Abbett (June 2024). Dividend Growers Could Be Well Positioned for the New Rate Regime