Most investors are aware that returns on dividend-focused stocks are affected by interest rates. Dividend yields do not actually move in lock-step with either long-or short-term interest rates, and as can be seen in Figure 1, and can diverge from one another for extended periods of time, with ramifications for relative returns. Given that the Federal Reserve has been on an interest rate targeting regime since the mid-1980s, it is natural to ask how Federal Reserve policy actions have affected the returns of dividend-focused stocks. Specifically, we set out to explore whether it has historically been preferable to invest in dividend-focused stocks when the Fed monetary policy is easy rather than tight. In order to do this, we compared dividend-focused stocks both to the alternative of investing in fixed income as well as to investing in the overall market as represented by the S&P 500.
Figure 1. Dividend yields, the Fed funds target rate, and 10-year U.S. Treasury yields
Monetary policy and investor preferences. In devising tests of how monetary policy affects returns on dividend-focused stocks, it is reasonable to start by exploring the mechanism through which interest rate changes lead to investor actions. For many years, financial theorists argued that investors should not care about whether their returns came in the form of dividends or capital gains. If an investor needed cash he or she could always sell stock. In recent years, however, researchers have focused on what is called the “clientele effect,” in which different groups of investors (the clienteles) prefer different dividend policies. Examples of investors who may prefer to hold dividend-paying stocks include retirees living on fixed incomes and endowments prohibited by trust agreements from “invading principal” to support their spending.
Researchers have found evidence that some investors tend to “reach for income,” shifting into assets that provide high current income when interest rates are low.1 They have also documented the tendency of high-dividend equity funds to receive inflows when interest rates fall, which seems to drive up the prices of high-dividend stocks.2 The picture that emerges is that when the Fed reduces interest rates it induces investors who wish to preserve income to shift into dividend-focused stocks from interest-paying substitutes such as money market instruments and bonds.
The tests. For dividend-focused stocks, we included in this analysis two well-known dividend-oriented strategies—investing in dividend growth stocks and investing in high dividend stocks. As a proxy for dividend growth strategies, we look to the S&P 500 Dividend Aristocrats Index3 which consists of a list of companies—mainly well-known, large-cap, blue-chip companies—in the S&P 500 with a track record of increasing dividends for at least 25 consecutive years. As a measure of the returns to a high dividend strategy we looked at the DJ Select U.S. Dividend Index4 a broad market index which tracks stocks with the highest dividends.
As a measure of returns on fixed income substitutes for dividend-focused stocks, we looked BBB-rated corporate bonds (by far the largest segment of the U.S. corporate bond market); a broad basket of all widely-traded bonds, including corporates, U.S. Treasuries, and mortgage-backed securities; and U.S Treasuries. To represent these products, we used Bloomberg’s US Corporate Investment Grade Index, the Barclays Aggregate U.S. Total Return Index, and the Bloomberg US Treasury Total Return index, which includes Treasury securities with maturities of over one year. We also looked at the returns on the S&P 500 because some commentators and investors are inclined to judge the performance of dividend-focused stocks against other kinds of equities.
Measuring the Federal Reserve’s policy stance. Fed-watchers and the Fed itself have long debated about whether the central bank’s policy stance is easy or tight. Although the Federal Open Market Committee, the policymaking body of the Federal Reserve, has often characterized its policy as “accommodative” or as “needing additional firming” in its post-meeting statements and minutes, this description is subjective. In particular, it does not distinguish between the stance of monetary policy (easy, neutral, or tight), or whether the FOMC is easing, on hold, or tightening. The distinction between the stance and direction of change in policy, moreover, is not always clear. Sometimes the market, interpreting a hike in the Fed funds rate as the beginning of a new tightening round, will react immediately, raising interest rates across the entire term structure of bond yields. In cases such as these, the market has responded to an initial change in policy by tightening monetary conditions, possibly for months to come, without further Fed action. Some researchers have used the Fed funds rate or the discount rate as a measure of the stance of Fed policy, but policy rates, money market rates, and bond yields have been on a multi-decade downward trend, making comparisons of interest levels across years questionable. A 5% Fed funds rate today would represent an unambiguously tight policy stance; that rate would not have seemed especially tight in mid-1997 when 10-year Treasury yields were 6.5% and GDP was growing at a 4.7% annual rate. What is needed is a measure of Fed policy relative to a measure of neutral monetary conditions.
In our tests we used as an indicator of monetary policy the difference between the Federal funds rate and R*, a measure of the “neutral” short-term interest rate — one that is consistent with GDP growing at its long-term potential rate and stable inflation. If this difference was less than -.5 (half of one percent) we classified monetary policy as easy, if between -.5 and .5 we considered policy to be neutral, and if greater than .5, we considered it tight. As can be seen in Figure 2, both the Fed funds rate and R* have been declining on trend, but have differed from one another substantially for extended periods of time.5
Figure 2. The Fed funds rate and R* — the neutral rate of interest
Our indicator does not take into consideration quantitative easing – the massive buying of bonds by the Federal Reserve in an effort to reduce long-term interest rates. However, quantitative easing has coincided with exceptionally low Fed funds rates. Indeed, the Fed launched quantitative easing in late 2008 as the Fed funds rate approached zero and the Fed became concerned it had lost its effectiveness as a policy tool. Thus the low Fed funds rate, in absolute terms as well as relative to R*, still signals easy monetary conditions.
We compared returns when investing in equities vs fixed income for the various monetary policies:
- Invest in equities when monetary policy was easy, otherwise invest in fixed income;
- Invest in equities when monetary policy is neutral, otherwise invest in fixed income;
- Invest in equities when monetary policy is tight, otherwise invest in fixed income.
The table below shows the total return of the strategies for each of the equity and fixed income products.
Source: Bloomberg, Heckman Global Advisors
Conclusions:
The data indicates that, in general, the strategy of investing in equities versus fixed income during times of monetary easing has been higher than using this strategy for equity investing during times of monetary neutrality or tightness. Also, during monetary policy easing, investing in dividend focused equity strategies using this strategy has a higher return than investing in the S&P 500 using this strategy.
1 Daniel, Garlappi, and Xiao, “Monetary Policy and Reaching for Income,” Journal of Finance (June 2021).
2 Jiang and Sun, “Reaching for Dividends,” Journal of Monetary Economics (November 2020).
3 The S&P 500 Dividend Aristocrats Index was launched in May 2005. Performance data before that date was backfilled.
4 The DJ Select US Dividend Index was launched on November 3, 2003. Performance data before that was backfilled.
5 See Laubach and Williams, “Measuring the Natural Rate of Interest,” Review of Economics and Statistics (November 2003). Their R* is a real interest rate. Because market participants are more familiar with nominal interest rates we converted R* into a nominal rate by adding to it the expected one-year inflation rate from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters.
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