Key Questions: Should Investors Consider Dividend Stocks in a Falling-Rate Environment?

In the immediate aftermath of the COVID-19 pandemic, options for higher-yielding securities were limited as interest rates hovered near historic lows. This environment would persist for several years, giving rise to the acronym TINA (There Is No Alternative). Yet, for investors seeking income, one option remained: dividend-paying stocks.

In 2022, however, the low-interest-rate environment ended as the Federal Reserve hiked interest rates aggressively to levels not seen in decades, with the intention of fighting inflation. This policy decision resulted in bond yields rising considerably and encouraged investors to explore alternatives previously unappealing to achieve desired yield targets. Dividend stocks consequently weakened as more attractive yields and the perceived safety of the other the investment choices shifted money flows away from dividend stocks. In brief, the competitive pressures from the flurry of new options cut into the demand for dividend stocks and valuations for these stocks declined.

However, the environment is now evolving once again, with inflation cooling and unemployment increasing. The Fed has reacted by reversing policy and has started the process of lowering rates in hopes of achieving a “soft landing” or “no landing” outcome. While two rate cuts have already occurred, more are expected over the next year. Given this outlook, the question now becomes, “Should investors consider dividend stocks in a falling-rate environment?”

While U.S. stock prices have increased substantially over the past year, dividend stocks have lagged the broader market. This could be attributed to the effects from higher bond yields but is also likely due, in part, to the strong performance from technology-related companies. Dividend stocks often lack representation from technology-related companies, as these companies are generally more focused on growth versus dividend payouts.

While every company is different, dividend stocks typically represent ownership in companies that are generally more mature, as future growth options have become more limited. These more established business models reduce the need for reinvestment in the business and tend to result in higher dividend payouts. On the other hand, tech companies with burgeoning business models and higher growth opportunities tend to require the reinvestment of capital to meet the high growth expectations of investors.

Positively for dividend stocks, as the Fed enters an easing cycle, the group appears to be positioned more favorably going forward. Given that dividend yields should become more attractive as bond yields fall, the expectation for lower rates presents an opportunity for investors to enter a dividend class that has not fully participated in the recent stock rally and trades at a lower valuation versus the broader market. As we move forward through the easing cycle, the relatively more attractive dividend yields should increase demand for dividend-paying stocks, supporting the stock prices.

Additionally, dividend stocks that commonly carry higher debt loads (i.e., utilities) should experience a direct benefit from the lower interest due to a reduction in the cost of borrowing for these companies. Dividend stocks could also provide an alluring outlet for investors weary of stretched valuation levels in the growthier parts of the market, further driving demand.

Moreover, there remain other benefits outside just the relatively more compelling yield opportunity. Dividends help provide liquidity to meet the income needs of the investor, which may be vital for certain investors. Dividend stocks can also act defensively in down markets, as companies paying dividends tend to be more mature with stronger cash flows. Finally, the dividend component can mitigate price volatility because the dividend payment should remain steady during difficult times. During the uncertainty of a rate cutting macro environment, and the still present recessionary risks, these benefits provide additional assurances that should be welcomed by investors.

While dividend stocks have been more of an afterthought of late, the rate environment for dividend stocks has been improving and is expected to continue to improve in the future. As the Fed enters an easing cycle and as bond yields reverse from the highs, dividend stocks appear to be presenting a compelling opportunity for investors. The key point is that dividend stocks appear poised to provide a strong prospect for both income and price appreciation to all interested investors.