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Interest rates are on the rise.
Since the election, the yield on the 10-year U.S. Treasury note, a bellwether yield for long-term interest rates, is up 70 basis points. A quote of 4.25% is the popular quote on a prime conventional 30-year mortgage. Six months ago, 3.5% was the popular quote for the same mortgage.
A lot of people think even higher interest rates reside in the future. Most of the prognostications I’ve run across say the Federal Reserve will raise the federal funds rate — the rate referred to when talk turns to the Fed raising interest rates — two or three times this year.
Traders also buy into the rising-rate narrative. Federal funds rate future contracts are priced with better than 50/50 odds that the fed funds rate will be 25-basis points higher by May, and then it will be another 25-basis points higher by November.
Higher Interest Rates and Your Stocks
So, what does this mean to our stock portfolio? The answer, we’ve been told, depends on the type of stock.
In a rising-rate environment coupled with improving economic growth, stocks with economically sensitive cash flows are expected to outperform most stocks. Non-dividend-paying growth stocks represent this segment.
As for dividend stocks, moderate-yield dividend growers are believed to have more stable cash flows than their non-dividend-paying counterparts. Consequently, their cash flows are perceived as less sensitive to the health of the economy than non-dividend-paying stocks. Dividend growers will continue to plug along.
As for high-yield dividend stocks, they’re expected to underperform their low-yield and non-dividend-paying counterparts when interest rates rise. With less cash flow to offset rising financing costs, high-yield stocks behave more like bonds and are more likely to suffer when rates rise.
At least that’s the conventional wisdom. But conventional wisdom doesn’t always jibe with reality. Don’t throw in the towel quite yet on your high-yield dividend stocks.
Good New for REITs
REITs are a popular class of high-yield dividend stocks. The good news is that listed equity REITs often increase in value when the Federal Reserve shifts from a stimulative policy to a neutral policy (a rising-rate environment). In fact, listed equity REITs posted a cumulative total return of nearly 80%, outperforming the S&P 500, when the Fed raised its target for short-term interest rates to 5.25% from 1% in 2004 through 2006.
The Vanguard REIT ETF (NYSE: VNQ), a high-yield equity REIT fund, has demonstrated strength and persistence since the Fed last raised interest rates in December.
But REITs aren’t the only high-yield investment class reaching higher ground in a rising-rate environment. Many high-yield business development companies (BDCs) have also reached higher ground since the December interest-rate increase.
To be sure, interest rates can influence equity values. But let’s also remember that earnings also influence equity values. I like what I see in recent earnings.
FactSet reports that with 92% of the companies in the S&P 500 reporting actual results for the fourth quarter of 2016, 66% of them beat the mean EPS estimate and 53% of them have beat the mean sales estimate. For the fourth quarter 2016, the blended earnings growth rate for the S&P 500 is 4.6%. The fourth quarter will mark the first time the S&P has seen year-over-year growth in earnings for two consecutive quarters since the fourth quarter of 2014 and the first quarter of 2015.
If earnings growth continues to trend higher, chances are good that stock prices will continue to trend higher as well, and that includes high-yield dividend stocks.