Long live the bond market bull. 

It started running in 1980, when a series of interest rate increases by the Federal Reserve finally broke the back of inflation, and it galloped onward for more than three decades. Yet the bond market bull died a quiet death on July 25, 2012, when the yield on the 10-year Treasury note fell to just 1.43%.

#-ad_banner-#Though 10-year Treasurys may see their yields drift lower once again if the U.S. economy slows down from its current pace, it’s hard to see yields ever again falling to the levels we saw last July. Back then, a looming government shutdown threatened to imperil the U.S. economy, spooking the bond markets, though no such shutdown is likely to happen in the future. Congress woke up and realized the foolishness of that possibility.

More than likely, that steady uptrend you see in the chart above will continue moving in that direction. Whether in a slow or rapid fashion, a firming U.S. economy will set the stage for higher rates down the road as bondholders demand higher payouts to offset the risk that increasingly vigorous economic activity may lead to higher inflation.

For investors, the key question is where bond yields will be when the U.S. economy is back in decent shape. And where bond yields land will have a direct impact on stocks as well, most notably dividend-paying stocks.

Tossing Out The Outliers
Just as the past few years have been quite anomalous in the context of long-term interest-rate trends, so were the 1970s. Many still recall the double-digit inflation and interest rates that decade, which were due to a confluence of factors that is unlikely to repeat. As the 1970s and the past few years should be seen as outliers in terms of historical interest rates, we should instead look at the era from 1980 to 2010 to see how interest rate trends played out. 

The 1980s were still affected by the bad memories of the 1970s, and the yield on the 10-year Treasury often exceeded 8%. By the early 1990s, inflation expectations started to dim and throughout that decade, we saw a steady drop in yields. Broadly speaking, we can look to the average yield on the 10-year Treasury over the past two decades and arrive at a figure just north of 4%. That’s roughly the interest rates seen from around 1998 to around 2008.

What’s so special about a 4% interest rate? That’s roughly the yield that gently brakes an economy from becoming overheated. (Indeed, a move above 5% in late 2007 gets some of the blame for an eventual sharp slowing in the economy in 2008.) Yet it’s not so high a yield that chokes off economic growth. In effect, in a moderately growing U.S. economy — let’s say in the range of 2.5% to 3% GDP growth — bondholders and the Fed would likely work in tandem to keep rates in the 4% range.

The good news: A 4% yield on the 10-year U.S. Treasurys has historically coincided with healthy stock markets. That yield simply isn’t high enough to pull vast sums out of the stock market and into the bond market, as was the case in the 1970s. 

Still, that’s not all good news for dividend-paying stocks. After all, the average yield on stocks in the S&P 500 is currently around 2%. As bond yields rise, stocks with that kind of yield will keep rotating out of favor until they offer up yields (and capital appreciation) that promises a better payback.

Let’s look at the major drugmakers as an example. As I noted last week, drug stocks traded for a number of years with dividend yields in excess of 5% to compensate for a lack of share price growth. Yet over the past year, these stocks have rallied higher, in part due to a firming broader market and investors’ search for yield plays. Merck (NYSE: MRK), for example, has rallied nearly 50% since October 2011, and its yield has fallen from above 5% to a recent 3.6%. 

When rates start to rise, will investors start to flee stocks like Merck? If that happens, a falling share price will boost the yield, creating a fresh entry point for stocks like this.

As we’ve noted in other recent columns, it’s really dividend growth that counts. Merck’s dividend was frozen at $1.52 a share for six straight years before a one-time 10.5% increase last year, to $1.68. The 2013 dividend was boosted another 2%, which is likely a sign of things to come. As you seek out dividend plays, look for companies that are capable of generating robust dividend growth such as Ford (NYSE: F), Intel (Nasdaq: INTC), JPMorgan Chase (NYSE: JPM) and others. 

Risks to Consider: It’s unclear how the bond market will respond to the eventual end of the Fed’s quantitative easing programs, especially as all of the liquidity that was pumped into the economy gets reabsorbed. So a chaotic bond market response cannot be ruled out. 

Action to Take –> More than likely, the remaining global economic headwinds will keep our bond market from running into trouble. Instead, look for an orderly and gradual rise in interest rates that leads investors to re-assess the appeal of various income-producing stocks. There’s no need to rush out and make radical moves now, but get ready to establish a long-term plan that accounts for changing interest rate trends.

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