Rising Rates: A Problem For Some Dividend ETFs

Since talk of the Federal Reserve tapering its bond-buying activities began in May, there have been two prolonged periods of rising 10-year Treasury yields. Or one period with a brief respite of declining rates. Fact of the matter is 10-year Treasury yields are a lot higher today than they were on May 22.

That day, 10-year Treasury yields were 2.03 percent before proceeding to climb to 2.73 percent on July 5. From there, the 10-year's yield would decline to 2.5 percent on July 19 only to soar 15.5 percent over the following month.

Rising Treasury yields are problematic for income investors on multiple fronts. Higher borrowing costs weigh on an array of favored dividend asset classes and sectors, such as MLPs, preferred stocks, REITs and utilities stocks. Higher borrowing costs are perceived to be a negative catalyst that forces REITs and MLPs to eschew dividend increases in favor of servicing debt while the bond-like element to preferred stocks makes that asset class sensitive interest rate increases.

Related: ETFs For Dividend Consistency.

Rising rates also plague some "old guard" dividend ETFs that are too heavily focused on predictable dividend sectors rather than future sources of dividend growth. Take the the SPDR S&P Dividend ETF SDY as one example.

The $12.3 billion ETF allocates just over 14 percent of its weight to rate-sensitive utilities and telecom stocks. Not an excessive amount, but enough to have sent the ETF down 3.3 percent in the past month, roughly the same amount the fund lost from May 22 through July 5. Bottom line: SDY is sensitive to rising interest rates. The ETF has shown itself to be so not once, but twice in the past 90 days.

Financial services, another sector that has a tendency to lag during rising rate environments, is 16.8 percent of SDY's weight. To be fair, SDY is not a "bad" ETF. Including dividends paid, the fund, which only includes companies that have raise their dividends for 25 straight years, has outpaced the SPDR S&P 500 SPY by 380 basis points over the past year.

However, if interest rates continue to rising, SDY and comparable dividend ETFs will be hurt not only by some of the sectors they do have exposure to, but those they lack decent allocations to.

Time For The New Guard
Some dividend ETFs have proven to be less bad than others as Treasury yields have spiked. The problem is, at least for some investors, is that some of the more compelling dividend ETF options are, well, new.

The WisdomTree U.S. Dividend Growth Fund DGRW is a perfect example of a "new guard" dividend ETF. It is a perfect example of a payout fund that has been less bad than its older rivals as interest rates have risen. In the past month, DGRW is off 1.5 percent. The newly minted fund lost 1.2 percent during the late May through early July rate spike, performances that easily top those of SDY over the same periods.

DGRW does not focus on backward-looking, superficial dividend increase streaks. The funds constituents are selected and weighted based on earnings expectations, return on equity and return on assets. Or factors that are integral to determining a company's ability to pay and grow its dividend in the future.

Then there is sector weight. "An analysis of the 13 rising-rate environments over the past 64 years found that the tech sector of the S&P 500 gained an average of 20% during the 12-month period following the first rate hike of each cycle. Health care stocks, meanwhile, represented the second-best-performing sector, with a 13% average gain," according to Investment News.

The worst-performing sectors, according to the Investment News piece, were financials and materials. Those sectors combine for less than 10 percent of DGRW's weight. Utilities are not found in this ETF. On the other hand, technology and health care combine for nearly 29 percent of the fund's weight.

Financials and materials combine for 28 percent of SDY's weight, but health care and tech combine for just under 13 percent.

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Disclosure: Author is long DGRW.