With rising interest rates expected to continue to put downward pressure on stocks and long-term bonds, advisors are revising their dividend-paying strategies. They’re also educating clients who may feel baffled about negative bond returns and too queasy to stick with the now volatile equities they’ve come to depend on for yield.

“It’s a very different scenario that we have to live with now that we’re going back to normalization [of rates],” says Tom Meyer, CEO of Meyer Capital Group, an RIA firm in Marlton, N.J. Normalization is overdue considering “the patient has been out of the ICU since June of ’09,” he says, referring to the economy and the recession.

For much of this decade, income-hungry investors have flocked to equities paying attractive dividends. “Who was going to go ahead and buy a one- or two-year Treasury and get 80 basis points,” says Meyer, “when you could buy Johnson & Johnson or any other blue-chip stock and get two, three, four percent.”

But as risk-free interest rates become more appealing (giving investors additional opportunities to capture yield), competition for capital will heat up, he says. The recent darlings of yield-seeking investors are already feeling the “crosscurrent” of rising rates, he says. REITs, MLPs and consumer-staple stocks “are getting absolutely crushed right now,” he says. “Bonds on the longer end are getting killed.” Utility stocks have also taken a beating.

Meyer expects the Federal Reserve to hike rates a total of three or four times this year and maybe a couple more times in 2019. He encourages investors to be patient, noting that market volatility will remain until the rate hikes are out of the way.

Investors should hold on to utility stocks they own and can selectively “dip a big toe in [the sector],” he says. “I don’t think the headwinds are over by any stretch of the imagination,” he says, “but it definitely creates an opportunity.”

He favors utilities based in the southern U.S. because its population influx supports growth. He also favors water utilities, noting, “Water is the most important commodity in the world.” Two of the nation’s largest publicly traded water utilities, American Water Works Company and Aqua America, yield only about 2% but have great growth potential, he says, particularly in their non-regulated businesses.

Meyer Capital Group has lowered the duration of its bond holdings by moving directly into one- and two-year Treasury bills. The bills now offer roughly the same yields as short-term bond funds, says Meyer, but are free of principal risk and state taxes.

The firm is pursuing dividends in foreign stocks and bonds through mutual funds and ETFs. European stocks have always paid higher dividends than U.S. stocks, he says, and Europe is at least two years behind the U.S. in normalizing interest rates.

Meyer uses several “go anywhere” alternative bond managers to try to reduce his vulnerability to higher rates and capture more yield than “a Plain Jane vanilla bond,” he says. Included in his portfolio are the Guggenheim Macro Opportunities Fund (GIOAX), the Osterweis Strategic Income Fund (OSTIX) and the Pimco Income Fund (PIMIX).

Seeking Balance

Gary Quinzel, a senior portfolio manager at AEPG Wealth Strategies in Warren, N.J., says the RIA has been very conscious the past few years about not over-stretching for yield (taking on too much credit risk to compensate for the low interest rate environment). But AEPG—like the other firms included in this article—takes a total return approach, is diversifying income across asset classes and has been preparing for higher rates for a long time, Quinzel says.

AEPG’s interest-rate outlook is tied to expectations for higher inflation. Quinzel and his colleagues think inflation will likely head north of 2% this year (exceeding the Fed’s target) because of higher wage growth, increased fiscal spending and, if they escalate, trade war tensions. To prepare, the firm is using the JPMorgan Inflation Managed Bond Fund (JRBSX) and a broad basket of long-only futures and commodity equities.

Stocks that previously performed well as bond proxies will “face continued headwinds as rates begin to rise,” says Quinzel. They’ll eventually be supported by investors’ move out of growth stocks and into value, but it’ll take a few more rate hikes and maybe a major geopolitical or economic event “to really spark that rotation,” he says.

He thinks such a transition could help more defensive sectors such as health care. But as higher rates impact future cash flows, he says, there may be further rotation out of high-growth sectors such as consumer discretionary and technology. And the flight from tech could hasten if Congress implements tougher privacy regulations, he adds.

However, “We really don’t make any sector bets,” says Quinzel. “It’s more of a broader look at growth versus value.”

Like Meyer Capital, AEPG has shortened its bond duration to try to dial back the impact of rising interest rates. “We also want to be active with our credit quality because we’re late in the [stock market] cycle,” says Steven Kaye, AEPG’s CEO and founder. Credit spreads are very narrow (so investors aren’t being compensated for taking greater risk) and high-quality bonds are more likely to hold up during times of stress, he says.

AEPG also invests in private real estate, which doesn’t fluctuate (as REITs do) with the daily volatility of the stock market. The firm’s investments are managed by a third-party real estate company and include multifamily, office, retail and warehouse properties.

Although AEPG has long been preparing its clients for rising rates, says Quinzel, “there is going to be a little bit of sticker shock” when they see negative returns on their bond portfolios. But history suggests these are short-term price losses, AEPG assures clients, and over the longer run the vast majority of total return from any fixed-income product comes from the yield component. As yields increase, “that’ll result in a higher return than if rates stayed the same,” he says.

The Center for Financial Planning, a Southfield, Mich.-based hybrid firm that’s part of Raymond James Financial Services, is diversifying its exposure to try to capture yield as rates trend upward, says Angela Palacios, the firm’s director of investments. The firm tries to balance dividend and growth strategies, and it derives income from stocks, bonds and its small real estate portfolio.

For investors nearing or in retirement, dividends “are a good regular source of a paycheck,” Palacios says. “[But] we don’t want to stretch and add unnecessary risk to our portfolio just to get those dividends.”

The center uses outside managers and has lowered the duration of its fixed-income portfolio quite a bit over the last couple of years, says Palacios. In this portfolio, “We also have the flexibility to utilize strategies that may look and feel like a bond,” she says, “but aren’t necessarily a bond.”

Early this spring, the firm introduced market-neutral strategies to its core bond sleeve (which houses investment-grade corporate securities and Treasurys) to reduce clients’ interest rate sensitivity. These strategies (which can go long or short on various assets) represent 20% of the firm’s core bond sleeve. That’s the same weight they have in its strategic income sleeve (which includes high-yield securities and emerging market debt).

Looking for Leaders

Dividends are a big focus for value investors FAI Wealth Management, a fee-only financial planning and investment management firm in Columbia, Md. “It’s a part of our DNA,” says Curt Gross, FAI’s chief investment officer.

The firm expects further rate hikes to have a disproportionate impact on equities, particularly those with static dividend payments. The de-risking of yield has recently begun, he says, noting that investors are shifting from equities to bonds.

FAI has never sought the securities that pay the highest dividends, says Gross, but rather those that can grow their dividends faster. He says the dividend growth for the equities in the firm’s portfolios, typically market leaders in fast-growing markets across all sectors, is currently 8% to 10%.

FAI is well positioned in the financial sector, which is expected to generate higher profitability if a steepening yield curve accompanies rising rates. FAI is also putting emphasis on the service industry. Over the past couple of years, says Gross, consumers have kept up their spending on services (including leisure, travel, health care and broadband entertainment), while cutting back their spending on goods.

FAI is shying away from the historically high-yielding telecommunications sector. Telecom companies face saturation in their main growth business in the U.S. (dissemination and use of cell phones) and declines in their legacy business (landlines), he says. “You’re not going to get the growth rate there unless they reinvent themselves,” he says. “It’s very similar in the utility sector.”

Many utilities are having a hard time growing their businesses (in lieu of acquisitions), because of regulatory issues and their very slow-growing customer bases, says Gross. If utilities use their cash flow for major acquisitions, they don’t have it to pay dividends, he says. FAI is also cautious about the energy sector, he says, because the firm thinks increased technology in the space will keep oil prices down.

On the bond side, FAI has shortened its duration and maturities. As a result, it’s lessened its interest-rate sensitivity. More important, says Gross, 10% to 20% of the firm’s bond portfolio is now maturing every year. FAI can reinvest the proceeds at higher rates rather than being locked in for years at lower rates, he says.

Bong Choi, the director of research for Wetherby Asset Management, a San Francisco-based RIA firm, notes that bond proxies (including utilities, REITs and MLPs) are highly leveraged and will see borrowing costs rise as rates rise. So investors must look closely at leverage and quality of management, he says, “and be very discerning.”

The firm is paying a lot of attention to MLPs for midstream pipeline companies. “The midstream space has been somewhat of an anomaly,” he says, “where you have continuing cheap valuations and incredibly attractive yields relative to other dividend strategies.”

Broadly speaking, yields in the space are 6% to 7%, he says, versus about 2% for the S&P 500, 3% for 10-year Treasurys and low-to-mid single digits for utilities and REITs. The U.S., now in the early stages of exporting natural gas, needs better pipelines, he adds, and President Trump is pushing for infrastructure spending.

Some investors have been turned off by the distribution cuts made over the last few years by midstream MLPs, says Choi. Instead, he argues that the cuts are largely to restructure the industry in a way that sets it up for more long-term resilience.

“You’ve seen incredible improvements in balance sheets,” he says, “and you’ve seen this interesting migration from MLPs to C corps” that should make midstream companies more palatable to institutional investors.

Wetherby Asset Management is looking to boost its exposure to real assets in order to find more income, increase diversification and protect purchasing power as inflation rises, says Choi.

“Income is a way to de-risk an investment in the long term,” he says, “because you are taking out cash as you sort of ride out your investment. Investors’ thirst for yield has continued unabated.”