Just when the Fed zigged, the treasury yield curve zagged. The widely expected March interest rate hike was supposed to help push fixed income yields higher too but then the opposite happened. Treasuries rallied on the news and the yields ended up dropping. So what happened? My take is that the market got a little spooked by the idea that the Fed may raise rates as many as two more times in 2017 in an environment where real wage growth is stagnant or maybe even declining. We saw a flight to quality on the notion that the Fed may hike too far, too fast and push the economy back towards recession.
If the treasury yields want to stay where they’re at, that could be good news for dividend equity ETFs. A couple of years ago, we saw traditional dividend-paying sectors such as utilities and consumer goods rally as investors searched for yields they weren’t finding in fixed income. A weaker than expected March jobs report, while not really an indication in and of itself that the economy is slowing, may give the Fed reason to keep a bit of a closer eye on things. If rates remain low and Q1 delivers strong year-over-year earnings growth (6-7% growth is currently forecast), dividend ETFs could be in a position to rally.
One of my top picks in the group right now is the Vanguard High Dividend Yield ETF (NYSEARCA:VYM).
This fund doesn’t focus on dividend growth or strength. It focuses on yield. The fund ranks dividend paying stocks by yield (REITs are excluded) and then fills the portfolio until the cumulative market cap of the fund reaches 50% of total available market cap. Since its market cap-weighted, the fund ends up primarily being invested in large- and mega-cap stocks. The fund’s current yield of 3.1% easily tops the 1.9% yield of the S&P 500 and the 2.3% rate on the 10-year Treasury note.
But higher yields can come with risks. REITs and MLPs can enhance a fund’s yield but also increase its risk and interest rate sensitivity (the fund reduces some of this risk by eliminating REITs right off the top). Stocks with higher yields could also be the result of weak company performance or a challenging business environment. Given the lack of REITs or MLPs in the portfolio along with the diversification within the fund (over 400 names in all), there’s not much evidence to suggest that either of these is a problem with this fund. Perhaps the bigger concern is the fund’s relative valuation. The overall P/E ratio sits at 21, well above the 18 multiple of the S&P 500, as traditionally conservative areas such as utilities and consumer goods and services have seen valuations stretched well above historical norms. The yields are attractive to income seekers but these areas could be particularly vulnerable if interest rates start rising.
