Vanguard High Dividend Yield ETF (VYM): Elevated Rate Environment Not Favorable

ETF Overview

Vanguard High Dividend Yield ETF (NYSEARCA:VYM) consists of high-quality large-cap dividend stocks. These are stocks that have consistently increased their dividends in the past and have been through several rounds of recession and continue to thrive. The fund pays a distribution yield of nearly 3%. However, given that the 10-year treasury yield is already over 4.2% now, this yield is not particularly attractive. With an uncertain economic environment in 2023 and a Federal Reserve that will continue to keep the rate elevated, we think investors can wait for further corrections before initiating a position.

Fund Analysis

Large-Cap stocks will fare better than smaller stocks in a recessionary environment

VYM’s portfolio consists of mostly large-cap stocks. In fact, large-cap stocks represent a little bit over 80% of the total portfolio. We know that large-cap stocks are generally stocks that have been through both flourishing and challenging times. In other words, they are likely going to survive in an economic recession and perhaps continue to perform well after the recession. Since 2023 is likely going to be a year of macroeconomic uncertainty, VYM’s portfolio of large-cap stocks should be able to give investors peace of mind in this volatile environment.

Although we have confidence that most companies in VYM’s portfolio will be able to sail through the storm in a recession, it does not mean they are immune to a recession. As the table below shows, cyclical sectors such as basic materials, financials, consumer discretionary, energy, and industrial sectors contribute to about 52.9% of its total portfolio. Together with the technology sector, which is still going through a rough time post COVID, these sectors represent nearly 59% of the total portfolio. These sectors will continue to face significant headwinds if a recession arrives or the economy continues to weaken. However, the good news is that VYM’s exposure to these sectors is more limited when compared to the S&P500’s exposure of 66%. Therefore, VYM will likely provide better stability than the S&P500 index in a recessionary environment.

Investors of VYM will earn a distribution yield of nearly 3%

Investors of VYM should be able to expect to earn a growing distribution. In fact, most of the companies in the top 10 holdings have increased their dividends for 10 consecutive years or more. The distribution yield is about 2.96% right now. As the chart below shows, VYM’s distribution yield is usually within the range of 2.5% and 3% in the past 15 years. Its current distribution yield of nearly 3% is towards the high end of this yield range. If we use 2.75% as the median point of the yield range in the past 15 years, VYM’s current yield of 2.96% is not expensive. However, given that the 10-year treasury rate of 4.2% is more than 120 basis points higher than VYM’s distribution yield, income investors who prefer safety should consider buying U.S. treasuries instead.

Should you buy VYM right now?

While inflation has dropped considerably in the past few months, it is still reasonably high. Therefore, it is likely that the Federal Reserve will continue to keep its interest rate elevated and perhaps higher if necessary for a lengthy period until inflation drops down to its target in the 2% range. We know that rising interest rates will have a negative impact on the valuation of stocks. Hence, VYM’s fund price will be impacted negatively if the rate continues to move up further.

Taming inflation is no easy task and could take time. The biggest component of inflation is labor costs. The current unemployment rate of 3.4% in January 2023 means that the Federal Reserve still has a long way to go to reach its target of 4.8% by year end. With a strong labor market, it will be hard to cool-off inflation without keeping the rate higher. The longer that the Federal Reserve must keep its rate high means the magnitude of damage to the economy could be larger. Therefore, as the year unfolds, we do expect business activities to slow and the economy to continue to decelerate. This has the potential to tip the economy over to a recession. With the advent of a recession, business earnings will likely decline, and it is very likely that the stock market could be faced with another round of corrections. VYM’s fund price would be impacted negatively as a result.

A declining fund price means that the distribution yield will move higher. If VYM’s distribution yield can reach above 3.5% as was the case back in 2020 or during the Great Recession in 2008-2009, it will provide a much better opportunity to buy than now. Once the yield reaches over 3.5%, the risk/reward profile will become much more favorable.

Investor Takeaway

We like VYM’s portfolio that consists of quality dividend stocks. However, given the macroeconomic uncertainty we are facing in 2023, we think investors can wait for further pullbacks before establishing a position.