The avalanche of money that flowed into low-volatility and high-dividend mutual and exchange traded funds over the past few years is rapidly heading for the exits as investors take note of the recent sharp increases in longer-term interest rates.

These higher yields are great news for savers, but they also provide income-seeking investors with an alternative to dividend-paying stocks. Unsurprisingly, the sharp upward movement in government bond yields has mostly caused fallout in the stock market’s most popular dividend-paying sectors: real estate investment trusts, telecoms, consumer staples and utilities.

Interest rates may reverse their current course again in the next few weeks, but we felt it was appropriate to review the basic proposition for investing in high-quality dividend-paying stocks such as those held in the Dividend Champions portfolio.

Our focus with the Dividend Champion selections is always the consistency and sustainability of the dividend payment. Therefore, we continue to look for solid balance sheets, abundant cash flow, limited pay-out ratios, reasonable valuations and sustainable and growing dividends.

Despite the long-term focus of our stock selections, there is no doubt that higher rates will have an impact on dividend stocks. First, we note that a return to a more normal level of interest rates would point to higher economic growth and inflation, which in turn indicates a more positive environment for company profit growth.

Second, the higher cost of debt may place considerable strain on companies that overloaded their balance sheets with debt during the extended time of super-low interest rates.

Third, the degree to which interest rates may rise will play a role in how attractive dividend paying stocks remain to be.

We have no crystal ball that can tell us where interest rates are heading. But we suggest that a sensible approach would entail using historical norms to estimate the real rate of interest, and then adding expected inflation to arrive at an expected nominal bond yield. This provides a baseline that can be used to compare dividend yields available in the equity market.

The table indicates our estimate of real bond yields observed over the long term in the U.S and Canadian markets as well as estimates of long-term inflation. Added together, these provide nominal bond yields – which readers will note are much higher than current bond yields.

What does this mean? First, that if long-term interest rates do indeed rapidly rise to the levels indicated in the table above, dividend yields will also rise – implying that prices of these stocks will decline. However, if this interest-rate adjustment takes place over an extended period, the negative impact on dividend-paying stocks may be limited because dividend payments normally grow over time.

With this background, we suggest that investors take a good look at the dividend income stocks currently held in their portfolios to ensure that these stocks will be able to perform even in a higher-interest-rate environment. We suggest that stocks held for dividend income purposes must meet the following criteria:

A sound balance sheet: Companies that built up high debt levels to take advantage of abnormally low interest rates will face higher finance costs. Dividend payments may be lowered or discontinued to be able to service debt.

A well-covered dividend: We prefer to see dividends well covered by profits and cash flow.

Sensible valuation: A high dividend yield does not necessarily mean that the company is attractively valued. Companies need to be compared on other relevant metrics against their peer group and against their own history.

Growing profits and dividends: Companies with high dividend yields but no growth are most likely to decline in value as bond yields go up. These are proxy bonds.

Apart from holding companies that can withstand shocks of a higher-interest-rate environment, we also take comfort from quality stocks that have dividend yields higher than current and expected bond yields. This, combined with reasonable dividend growth, should provide a total return well in excess of a bond investment.

The graph indicates the current and future dividend yields (taking dividend growth into account) of some of our Dividend Champions as well as the current and expected yield to maturity on U.S and Canadian government bonds. To my mind, investors are better off in quality dividend-paying stocks.

Of course, this does not mean that dividend-paying favorites will not decline as edgy investors spooked by higher bond yields depart. But we are comfortable that the income stream generated by our Dividend Champions will remain viable and growing over the medium to longer term.

For long-term income-seeking investors, high-quality companies with growing dividends remain an attractive option when compared to the meager returns still offered by bank deposits or government bonds. Interest rates may be on the rise, but our well-diversified Dividend Champions portfolio offers a dividend yield of around 4% with expected dividend growth of 5%-10% per year for the next few years. This still looks to me better than an investment in government bonds.