When interest rates rise, bond prices fall. And as we saw in 2022, when the S&P 500 fell 18.1% (with dividends reinvested), a tightening cycle by the Federal Reserve can be hard on investors of all stripes. But now, with inflation ebbing, investors who have been content to seek yields of 5% or higher on bank certificates of deposit or in money-market funds may be well served to add back some risk, according to Mike Loewengart, the head of portfolio management for Morgan Stanley Portfolio Solutions.
The Portfolio Solutions group at Morgan Stanley develops models to allocate money in portfolios for individual advisory clients. Loewengart had similar responsibilities at E-Trade before that firm was acquired by Morgan Stanley in 2020.
During an interview, Loewengart pointed to a risk faced by people with CDs. A depositor knows how much interest will be received and when, but there is no guarantee that when a CD matures, interest rates won’t have declined. “Any investor who has a longer-term horizon, and even retirees, still need to protect their purchasing power,” he said.
Let’s say you recently took out a 12-month CD. The big news on Wednesday was that the consumer-price index rose only 0.2% in June — the lowest U.S. inflation rate in almost two years. Bond yields have been falling, which means their prices have been rising. This could indicate even lower interest rates ahead, possibly from a Federal Reserve reaction to a slowing economy.
Consider that right now the yield on five-year U.S. Treasury notes
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is about 4%, while the yield on 10-year Treasury notes is 3.83%. The inverted yield curve (long-term rates lower than intermediate and short-term rates) shows that bond investors expect interest rates to decline. They expect to profit from bond-price increases. “That is the opportunity cost of sitting in cash,” Loewengart said. At the end of 2021, the five-year yield was only 1.26% and the 10-year yield was 1.52%.
With interest rates still high, this may be a good point to buy shares in a bond fund. These portfolios tend to trade at discounts to face value in the current environment. This means investors will enjoy capital gains as bonds mature, or take comfort from rising prices in the meantime if interest rates decline.
Loewengart also emphasized the importance of dividend-paying stocks, as steady increases in dividends mean investors can build income streams over the years. And the rising dividend payments, especially for companies whose sales and profits are steadily increasing, can help propel stock prices over the long term. “You will not get that sitting in cash. You potentially miss out on appreciation opportunities,” he said.
Here’s a recent article on the S&P 500 Dividend Aristocrats, which is a group of 65 stocks of companies that have raised their payouts on common shares for at least 25 years. These stocks don’t necessarily have high dividend yields. However, this indexing approach, which you can take with the ProShares S&P 500 Dividend Aristocrats exchange-traded fund
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has beaten the S&P 500
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on a total-return basis for several long periods.
The S&P 500 itself is weighted by market capitalization. That means Apple Inc.
AAPL,
Microsoft Corp.
MSFT,
Amazon.com Inc.
AMZN,
Nvidia Corp.
NVDA,
and two common-share classes of Alphabet Inc.
GOOGL,
GOOG,
together make up nearly 24% of the portfolio of the SPDR S&P 500 ETF Trust
SPY,
which tracks the benchmark index.
“There has been narrow market leadership” as the S&P 500 has returned 17.5% so far this year, Loewengart said, “with a handful of megacap names driving the market. This has happened before.”
He suggest that investors who prefer low-cost index funds might augment their exposure to the S&P 500 with exposure to an equal-weighted S&P 500 index fund. Recently we compared the two approaches and found that the Invesco S&P 500 Equal Weight ETF
RSP,
had beaten SPY’s total return over the past three years; had underperformed SPY for five years, 10 years and slightly for 15 years; and had outperformed SPY significantly over the 20-year period.
“Investors have an opportunity to regain their equity exposure in a more risk-managed way,” which includes “complementing” cap-weighted exposure with some equal-weighted exposure, Loewengart said.
Getting back to the subject of growing a dividend income stream, an interesting example of a mutual fund looking to take advantage of rising payouts is the $48 billion Schwab U.S. Dividend Equity ETF
SCHD,
which has a five-star rating (the highest rating) within Morningstar’s U.S. Fund Large Value category. The fund holds 100 stocks of companies that have paid dividends for at least 10 years and are subject to various quality screens. The fund has a “modest large-cap tilt,” according to FactSet.
A competing fund with a four-star rating is the $26 billion Franklin Rising Dividends Fund
FRDAX,
which holds 55 stocks and is more concentrated than the Schwab fund. Two of the fund’s managers described its approach during an interview in February.
A different type of equity-income fund that aims for high monthly distributions of dividend income from the stocks it holds, as well as fee income from covered call options, is the $28 billion JPMorgan Equity Premium Income ETF
JEPI,
The fund’s co-manager Hamilton Reiner explained its strategy in an interview.
Loewengart said that going in slowly is another way for investors to reduce risk. For example, an investor might use dollar-cost averaging, making regular periodic purchases within a brokerage account or retirement account, “to reallocate a certain amount of money each month over the next year, or over a five-month period, to get back into the market.”
Another way an investor can scale risk while moving back into the market is through guardrails, such as a percentage allocation to stocks and bonds, Loewengart said.
Through its E-Trade subsidiary, Morgan Stanley maintains recommended lists of mutual funds and exchange-traded funds. You can select broad categories of funds, including bond funds, at the top of each page.
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