Interest rates have drifted higher since the beginning of 2018. They’ve spiked mostly higher over the past 30 days.
Indeed, the yield on the 10-year U.S. Treasury note – a bellwether security for investors – rose 30 basis points in 30 days. That’s a spine-straightening move. The 10-year U.S. Treasury note yields 3.2% (a seven-year high) as I write.
Why should we – income stock investors – care?
Interest rates influence income-stock values. At the least, an interest rate is a discounting mechanism of future dividends: The higher the interest rate, the lower the present today (and vice versa).
If only it were that unambiguous. Stocks are heterogeneous. A multitude of variables influences an individual company’s value and dividend payout. How stocks react to interest-rate changes depends on the stock.
First, we need to consider that rising interest rates aren’t all bad. Rising interest rates can be both a blessing and a curse.
Rising interest rates are frequently a byproduct of rising economic growth (a blessing). At the same time, rising interest rates raise the cost of debt capital (a curse).
Fortunately, a growing economy supersedes low borrowing costs for many companies. But not everyone will benefit in equal proportions. Some stocks will outperform; others will still perform, but with lag.
Many technology stocks will perform.
Tech companies tend to carry a low debt load and a stable fixed-capital structure. This paradigm frequently leads to widening margins when sales accelerate in a growing economy. According to data analyzed by JPMorgan and Birinyi Associates, tech stocks have historically been the best-performing sector in the six months after interest rates begin to rise.
Banking is another dividend-centric sector that is expected to generate winners in a rising-interest-rate environment. Of course, life isn’t peewee soccer – not everyone wins.
If long-term rates rise and short-term rates remain near zero, banks that lend long (mortgage lending, for example) and borrow short will benefit. If short-term rates rise with long-term rates, banks with balance sheets festooned with assets sensitive to short-term rates – home-equity loans, credit cards, working-capital lines of credit – could be left in the dust.
Dividend growers might be the surest bet of all.
These stocks have historically outperformed in the wake of rising rates. According to data compiled by Ned Davis Research, three years after the Fed first hikes the federal funds rate, dividend growers have outperformed dividend nonpayers by over 17 percentage points.
Business development companies (BDC) should also see an uptick in fortunes with rising interest rates.
BDCs invest primarily in first- and second-lien senior secured loans of middle-market companies. The loans are typically floating rate. Rising interest rates will raise the interest rate BDCs can charge on their loans.
On the other side of the balance sheet, the liability side, the BDC debt is mostly fixed-rate and long term. Interest rates rise, but borrowing costs remain subdued. A stable debt structure combined with a floating-rate investment portfolio produce a rising tide of net interest income.
As for potential laggards, keep an eye on debt-dependent sectors.
Master limited partnerships (MLP) carry high debt. They could suffer if they need to refinance in a higher-interest-rate environment.
Investors also need to keep an eye on their real estate investment trust (REIT) investments, particularly mortgage REITs. Many of these REITs are heavily leveraged and carry interest-rate-sensitive debt. (I don’t recommend any mortgage REITs.)
Other REITs – namely equity REITs – can thrive as interest rates rise.
One investment firm reports that since 1979 there have been six periods of monetary tightening and rising U.S. Treasury yields. When U.S. Treasury yields are rising (as is happening now), REITs delivered average annual returns of 10.8%. In periods when the Fed was actually increasing interest rates, they performed even better with a 12.6% average annual gain.
So, what should we do?
I’m staying the course. I’m unfazed by rising interest rates.
Individual stock selection serves as the foundation for my confidence. We’ve selected income securities at High Yield Wealth that can thrive through every interest-rate season. We offer a portfolio of quality individual securities that we expect to perform whether interest rates rise, fall, or stand pat.
If you have confidence in what you own and recommend, why do anything else?