The Fed Won't Sink This Dividend ETF

In anticipation of the Federal Reserve raising interest rates, dividend exchange-traded funds have been under ample duress this year. Obviously, the Fed moved forward with its first rate hike in nearly a decade, leaving some dividend ETFs chock full of rate-sensitive sectors to face a world in which U.S. borrowing costs are expected to continue climbing next year.

Dividend Growers And The Fed

While richly valued, defensive, high-yield sectors are seen as vulnerable to hawkish changes in Fed policy, it could be the dividend growers and the corresponding ETFs that shine as interest rates rise. That should prove to be good news for funds such as the $281.3 million iShares Core Dividend Growth ETF (iShares Trust DGRO).

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DGRO follows the Morningstar US Dividend Growth Index, which requires constituent firms have a minimum of five years of uninterrupted dividend growth. The index also purposefully avoids stocks with high and potentially unsustainable dividend yields by excluding firms with yields that rank in the top 10 percent of the eligible inclusion universe and only companies with a payout ratio of less than 75 percent can be included, according to Morningstar.

“The previously low interest rate environment paved the way for many of these defensive businesses to load up on debt to expand their operations, while continuing to pay high dividends to investors. As such, many of these companies will likely come under pressure when rates rise,” said iShares in a recent note.

“In contrast, dividend growth stocks have historically demonstrated less interest rate sensitivity and may be an attractive way to maintain yield in a rising rate environment. In contrast to high dividend payers, they tend to be more reasonably valued and have more potential to sustainably grow dividends over time.”

Looking In On DGRO

DGRO, which is 18 months old, allocates about 37 percent of its combined weight to industrials and consumer staples, but the ETF's over 14 percent weight to technology stocks is healthy among U.S. dividend ETFs. DGRO's 2.25 percent trailing 12-month dividend yield is just one basis points where 10-year Treasury yields closed Thursday, confirming that DGRO is not an ETF to be feared, even as interest rates climb.

DGRO's top 10 holdings feature nine Dow stocks with PepsiCo, Inc. PEP being the outlier. Other top 10 holdings in DGRO include Microsoft Corporation MSFT and Exxon Mobil Corporation XOM.

“So, although rates are expected to moderately increase, you can prepare your portfolio now for a rising rate environment by considering simple actions such as these. These simple steps may help to insulate your investments while also capturing new opportunities,” added iShares.