Dividend Stocks In A Rising Interest Rate World

Ellen Roseman Dividend stocks are a popular choice as interest rates stay low. I’m a fan of the strategy and I own many Canadian banks, utilities, pipelines and telecom stocks, yielding three to five percent, in my own investment accounts.

But is the love affair too hot and heavy? Some investors see blue-chip stocks with healthy dividends as a substitute for fixed-income investments. I disagree. In the short term, dividend stocks can disappoint.

Unlike a GIC whose principal value never goes down, high-yield shares can take a steep dive when interest rates rise. Just the threat of a rate hike can lead to price declines.

If central banks start worrying about inflation and decide to increase rates to keep prices stable, dividend stocks could falter. The gap between their yield and the risk-free rate of return on interest investments will shrink.

This happened in January to June 2015, when the U.S. economy was improving and the Federal Reserve hinted that rate hikes were on the horizon. My own taxable stock portfolio was down 1.7 percent for the year, though it has recovered in 2016.

If you can’t bear the thought of a capital loss, you won’t find a safe haven in dividend stocks. It may take a year or more to recoup your money if rates are poised to go up and even longer to realize capital gains.

To invest in dividend stocks, you must recognize that their market value will fluctuate, sometimes violently, with the prospects for higher interest rates. Patience is a huge asset.

However, if you can overlook daily price changes and focus on the quarterly or monthly income you receive, you will find it a rewarding experience to own a piece of Canada’s largest and most stable companies.

Over a holding period of five to 10 years, you should see a positive return made up of dividend yield, dividend growth and capital gains. You simply have to choose your stocks carefully and monitor their progress every few months.

Here Are Some Advantages Of A Dividend Investing Strategy.

Large companies hesitate to cut their dividends unless their cash flow plunges. They try to maintain them or raise them regularly. Fortis (TSX: FTS) has raised its annual dividend consistently for 43 years. Canadian Utilities (TSX: CU) has had uninterrupted dividend increases for 44 years. Top dividend growers in the U.S. include Johnson & Johnson (NYSE: JNJ), McDonald’s (NYSE: MCD) and Realty Income (NYSE: O).
As a dividend investor, you can focus on annual income rather than on daily price swings of the stocks you own. Since dividends rarely decline and tend to rise from year to year, you will be less tempted to sell and more likely to stay invested when stock markets take a dive. This new outlook increases your odds of success.
Reinvesting dividends allows you to build your holdings easily. You can set up a dividend reinvestment plan (DRIP) with the stock issuer and receive fractions of shares each quarter or month with no commission fees. Another option, called a synthetic DRIP, is to ask your online broker to reinvest your dividends at no charge. However, you must collect enough income each quarter or month to buy a full share.
Reinvesting dividend income will boost your returns, since your money compounds with each share purchase. LongRunData.com, a U.S. website, has a dividend reinvestment calculator that shows the growth of $1,000 over time. Shares of RBC, Canada’s largest bank, had a 16.49 per cent annualized return in the past 20 years, meaning that a $1,000 investment is now worth $24,215. CNR’s annualized return is 19.63 per cent and a $1,000 investment has grown to $34,612.
A dividend portfolio can help you keep up with inflation in retirement. It’s like owning a real estate property in which the tenants’ rents go up gradually each year. Instead of relying on a fixed and shrinking income from company and government pensions, you will have a source of income that is rising.
The money in your registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) can last longer if you own dividend stocks in a non-registered account from which you draw income in retirement. You will have more flexibility in withdrawals. Meanwhile, using dividends to supplement your income can extend the life of your registered savings and cut your tax bill.

Here Are Some Tips On Implementing A Dividend Investing Approach

If you have a small amount to invest ($10,000 or less), you can buy an exchange-traded fund (ETF) that holds dividend stocks. A frugal choice is the iShares Core S&P/TSX Composite High Dividend Index ETF (TSX: XEI) with a management expense ratio (MER) of 0.21 per cent. In contrast, the iShares S&P/TSX Canadian Dividend Aristocrats Index charges three times as much (its MER is 0.66 per cent).
Decide where to hold your dividend stocks and ETFs. With a tax-free savings account (TFSA,) you can avoid paying tax on your annual income and any capital gains when you sell. With an RRSP, you have tax-free growth while the money is in the plan, but you pay tax at your highest marginal rate on all withdrawals.
Do you want to DRIP? It is easier to reinvest dividends inside an RRSP or TFSA, since you don’t have to pay tax. It’s trickier in a non-registered account, which requires reporting each purchase of fractional or single shares for tax purposes. As an alternative to using a DRIP, you can hold on to your dividends and reinvest them yourself when you have a large amount of cash.
You have to do some homework. Make sure you hold the right products and you do not lag the market indexes or benchmarks. If you prefer, you can delegate the work to a financial advisor who will choose dividend stocks and monitor them for you. Some advisors charge annual fees, while others charge commissions on each trade.
Many personal finance bloggers follow a dividend growth strategy. It is fun to watch their progress and check out their stock picks. I like Mark Seed’s blog, My Own Advisor. Other favourites are 25000dividends.com, DividendEarner.com and MillionDollarJourney.com. And for basic information, go to DripInvesting.org.

Ellen Roseman, Toronto Star business columnist, investing for beginners instructor at University of Toronto continuing studies, board chair at FAIR Canada, an investor advocacy group. eroseman@thestar.ca, www.ellenroseman.com, @ellenroseman on Twitter.