Can dividend stocks compete with bonds?

With volatile equity markets and higher bond yields, dividend-paying stocks are facing headwinds.

“Equities, especially dividend-paying equities that Canadians hold so dear, are getting severely punished as of late, and that’s largely due to the relative rise in bond yields,” said Craig Jerusalim, a senior portfolio manager at CIBC Asset Management, in an interview on Oct. 25.

Listen to the full podcast on Advisor To Go, powered by CIBC.

The yield on 10-year U.S. Treasuries briefly topped 5% last month as investors anticipated interest rates remaining high for longer than previously thought. After central banks in Canada, the U.S. and Europe held their overnight rates, bond yields have dipped slightly while remaining high.

“The problems we see with rushing into these securities indiscriminately is the fact that we are just so early in this current economic cycle,” Jerusalim said. “Central banks are likely to continue with their hawkish commentary, even if we are in the final innings of interest rate hikes.”

Last week, Federal Reserve Chair Jerome Powell did not rule out another rate hike, while Bank of Canada deputy governor Carolyn Rogers warned that interest rates might not return to low levels.

Jerusalim said central banks’ hawkish stance is driven by the desire to prevent a re-acceleration of inflation and avoid repeating the boomerang experienced in the 1970s. This means that rate cuts are unlikely until further economic pain is felt.

The good news for equity investors, he said, is they don’t need to wait for bond yields to drop before seeing a separation emerge between higher-quality securities that fell alongside the more poorly positioned ones.

In this environment, Jerusalim said investors should look for companies with low leverage, strong pricing power, sustainable competitive advantages, good growth characteristics, and reasonable valuations. These qualities become especially important in a stagflationary environment, where the rising cost of debt payments and inflationary pressures can impact returns.

“It is often a good trade-off to pay up for quality,” he said. “We just don’t want to be overpaying for tomorrow’s growth today.”

Regarding dividend-paying stocks, Jerusalim said investors should assess the sustainability of dividends and prioritize companies that can grow their dividends over time. In uncertain economic times, he said dividends become a much larger percentage of total returns, making their sustainability a factor for long-term investors.

Looking forward, if central banks decide to lower interest rates earlier than expected, Jerusalim anticipates a resurgence in sectors offering higher yields and growth potential, such as telecom, utilities, real estate investment trusts (REITs), select financials, and technology companies with long-dated cash flows.

However, he said it is more likely that interest rates stay higher for longer. In this scenario, he said investors can find opportunities by focusing on stronger companies with robust balance sheets, better growth prospects, and solid fundamentals — companies that are “able to survive any downturn and are best positioned to thrive once economic conditions improve,” he said.

Jerusalim considers the energy sector particularly attractive, based on four factors: demand, supply, starting valuations, and ESG considerations.

Demand for energy, Jerusalim said, remains robust due to continued growth in emerging markets such as China and India. On the supply side, dynamics have shifted, and investors are now focusing on profitability over growth.

Valuations for energy companies also remain attractive because even if multiples stay where they are, Jerusalim said cash-flow growth will lead to higher dividends and returns to shareholders.

Within the financial sector, Jerusalim said there is a discrepancy between banks and insurance companies, specifically property and casualty (P&C) insurance companies and reinsurers. He said favourable fundamentals are driving P&C companies due to hard market conditions, shorter-duration books, and portfolios that benefit from higher interest rates.

“Relative to the banks, which are very cheap right now, the P&C companies have a much better risk-return profile,” he said.

Jerusalim said that despite the appealing attributes of Canadian banks, it may be too early in the economic cycle to overweight them in a portfolio. Instead, he recommends a more tactical approach, anticipating trends such as provisions for credit losses and restructuring charges to play out before increasing exposure.

This article is part of the Advisor To Go program, powered by CIBC. It was written without input from the sponsor.