Is high-yield equity worth considering when rates rise?
The Fed is raising interest rates this year, which is often viewed by advisers and their clients as a time to abandon stocks with high yields.
Indeed, conventional wisdom says that high-yield stocks suffer when rates go up. But that’s not necessarily true, according to a study from MSCI.
The index firm looked at the performance of these equities when the Fed raised rates. It turns out that over the 88 years through July 2015, when 10-year rates have been low (less than 3%), high-yield stocks have outperformed the market by an annualized 2.4 percentage points as the Fed tightened.
For those looking for a way to harness this outperformance, here is a closer look at the four largest exchange-traded funds that focus on domestic high-yield equities:
Vanguard High Dividend Yield (VYM, expense ratio: 0.08%) is the largest high-yield stock ETF with $17.6 billion in assets. The fund’s 30-day SEC yield on March 29 was 3.01%. The fund tracks the FTSE High Dividend Yield index, a subset of the FTSE USA index. All the dividend payers in the FTSE USA are ranked by their indicated 12-month consensus dividend yield and roughly the top half of that universe constitutes the benchmark. The market cap-weighted index does not include REITs. At the end of February, the ETF held 415 positions with financial services, consumer staples and technology the largest sectors. Through March 29, the Vanguard High Dividend Yield fund had a one-year total return of 16.10%.
PowerShares S&P 500 High Dividend Low Volatility (SPHD, 0.30%) holds $3.1 billion in assets and had an SEC yield of 3.72% on March 29. The 50-stock portfolio starts with the 75 highest-yielding issues in the S&P 500 and removes the 25 stocks that exhibited the greatest volatility over the previous year. Stocks are weighted by dividend yield. In Morningstar’s large value category, this fund’s performance (based on NAV) ranked first in 2014 and 2015, and fourth in 2016. Through March 29, the fund’s one-year total return was 13.80%. The largest sectors are utilities, real estate and consumer staples.
WisdomTree High Dividend (DHS, 0.38%) holds more than 400 U.S. stocks and has assets of $1.26 billion. On March 29, the ETF’s 30-day SEC yield was 3.31%. The underlying index requires components to have a minimum market cap of $200 million. Only the top 30% by yield make the final cut. WisdomTree weights the underlying index by the proportionate share of the aggregate cash dividends each company is expected to pay in the coming year. Top sectors are consumer staples, real estate and health care. The one-year total return for this fund was 12.17% through March 29.
PowerShares High Yield Equity Dividend Achievers (PEY, 0.54%) is the only one of the largest high-yield ETFs that requires dividend growth. Based on the Nasdaq US Dividend Achievers 50 index, PEY holdings must have at least 10 consecutive years of dividend increases. The 50 highest-yielding issues are included in the fund and are weighted by their 12-month trailing yields. Sector weighting is capped at 25%, which was not always the case. Before sector caps were imposed, this PowerShares fund was heavily invested in financial services stocks heading into 2008. That significantly clipped the ETF’s 10-year performance, though its one-year total return through March 29 was 23.71%. Top sectors are utilities, consumer staples and consumer discretionary.
As always, use caution. Past performance does not guarantee the future. But as the MSCI study shows, rising rates historically have not impeded the performance of high-yield stocks. If the Fed follows through with two more gradual rate increases this year, stock prices should not suffer. The highest-yielding equities should continue to outperform.