The coming year could be a tricky one for income-minded investors. Interest rates are expected to rise, increasing overall yields but also likely resulting in stock price volatility. The resulting lower stock prices also mean the yields on many dividend-paying stocks are adjusted upward.
Some dividend-paying companies are well-equipped to handle rising rates, as well as the inflation they’re meant to curb. Many of them will even increase their payouts to reflect rising costs, protecting their stock’s price.
This creates a bit of a conundrum. Are the market’s highest-yielding names going to maintain their strong yields but also maintain their stocks’ prices? Or, are the highest-yielding stocks also the most vulnerable dividend payers as we move into 2022? Here’s what you need to know.
Strangely high yields aren’t a red flag
As of mid-December, the Federal Reserve anticipates that the baseline Federal Funds Rate will end the coming year three-quarters of a point higher than where it is right now. By the end of 2023, it’s apt to be another three-quarters of a point higher. And, given that consumer (as well as producer) price indexes just hit multidecade highs in November, the outlook seems anything but outrageous. The Fed will have to do something sooner rather than later to curb the potentially adverse impact of soaring prices. Interest rates on bonds issued in the meantime will reflect those higher rates, while prices of bonds already in investors’ hands will sink as well, to put their yields on par with newly issued debt.
But it’s not just bond yields impacted by rising interest rates. Inasmuch as bonds compete with dividend stocks for income investors’ attention (and dollars), dividend stocks can also be pushed and pulled by changes to the prevailing interest rate. The higher the dividend yield, the more vulnerable the stock. That’s what makes some of the S&P 500‘s (SNPINDEX: ^GSPC) highest-paying names a bit uncomfortable to buy at this time, despite their well-deserved blue-chip status.
PPL Corp. (NYSE: PPL)
Valero Energy (NYSE: VLO)
Oil & gas refining
Philip Morris International (NYSE: PM)
Dow (NYSE: DOW)
IBM (NYSE: IBM)
How they will be pushed and pulled is the tricky part here. Just because the interest rate dynamic can work against a dividend-paying stock’s price doesn’t mean it will. A company may well be able to stand up to inflation. In some cases, a company might even benefit from more pricing power and pass that upside along to shareholders in the form of additional dividends.
Take Valero Energy as an example. The oil refiner buys crude oil at market prices, but turns around and sells gasoline and other petroleum-based products also at market prices. Its competitors do the same, and none of them have a significant cost or price advantage compared to one another. And, while we all may grumble about rising prices at the pump, we all still pay those higher prices.
Tobacco giant Philip Morris International operates in a similar dynamic. That is, while the price of tobacco can ebb and flow, so does its pricing power. For better or worse, smokers will pay almost any price to maintain their habit. Ditto for chemical outfit Dow. Utility provider PPL is yet another inflation-resistant company. Higher power production costs — electricity generated by sources ranging from natural gas to coal to solar to nuclear — are also readily passed along to its customers.
As for IBM, it may not enjoy additional pricing power in an inflationary environment. But technology and R&D costs aren’t exactly volatile from one month or even one year to the next. Ol’ Big Blue doesn’t exactly need additional pricing power, so its dividend is protected too.
Don’t overthink it
While these highest-yielding names of the S&P 500 may be safe from the inflation that’s rattled consumers, that doesn’t guarantee the market won’t re-price them as if they’re at-risk names. Perceptions and assumptions are powerful.
The thing is, investors may have already unknowingly done this. Any stock yielding more than 5% is already miles away from the S&P 500’s average yield of around 1.3%. It’s even greater than the S&P 500 High Dividend Index’s current dividend yield. This index, which only includes the highest-yielding 80 stocks of the S&P 500, sports an average yield of around 4% right now. Clearly, the market already sees something different with these five names.
If any of these tickers are on your list of prospective dividend stocks to buy, though, don’t be afraid to do so. Investors are collectively underestimating these stocks’ resiliency to inflation and subsequently rising rates. Income seekers can secure above-average dividends from companies that are more than solid enough to own — and continue finding their big payouts — for the long haul.
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