It’s a turnaround, and it’s a big deal if you’re an income investor.
The Federal Reserve has changed course on interest rates.
After one increase in the first half of the year, three decreases have followed in the second half.
Why should we care?
Interest rates influence stock prices – a lot.
When interest rates change, so do stock prices.
But stocks are an assorted lot. Generalities won’t work.
Amazon (NASDAQ: AMZN) and Exxon Mobil (NYSE: XOM) are both stocks. No intelligent investor thinks the one is a business twin to the other.
Different stocks respond differently to interest-rate changes.
Growth stocks will outperform value stocks when interest rates are rising. The best time to invest in growth stocks is when sentiment floats on an undercurrent of optimism.
Investors flocked to growth stocks when the Fed raised interest rates for the first time in December 2016. Growth stocks have outpaced the S&P 500 and dividend-dominated value stocks in the months that followed.
Growth held its advantage – until recently.
Value stocks (dominated by dividend payers) have rallied on the interest-rate cuts.
High-yield investments have rallied more than most. This makes sense.
Many high-yield investments are perceived as bond surrogates. They’re valued more for their immediate income and less for their growth potential. When interest rates fall, the value of the dividend stream rises.
I offer a hypothetical example for the income investor.
Let’s say that you own an investment that pays $100 annually, and will do so each year thereafter.
If long-term interest rates are 5%, that $100 annual payment would be valued at $2,000 ($100 divided by 5%).
Look what happens when interest rates fall.
If interest rates drop to 2.5%, that same investment is valued at $4,000 ($100 divided by 2.5%).
It’s that simple because interest rates are a simple discounting mechanism applied to future cash flows.
Now, let’s transition to reality. I offer a long-time high-yield favorite of mine as an example.
Gladstone Commercial Corp. (NASDAQ: GOOD), a commercial real estate investment trust (REIT), owns a diversified portfolio of commercial, retail, and industrial properties.
Gladstone pays a $1.50 annual dividend per share. It has paid that dividend since I first recommended its shares in September 2012.
Gladstone shares were trading at near $20 as we entered the second half of 2019. They trade near $23 today.
The prospect of sustained low-interest rates has raised the value of Gladstone’s dividend stream. It’s helped raise Gladstone’s share price.
A 15% move in five months might appear to be a piddling move if you’re a go-go growth investor. Gladstone isn’t bought for growth, though. It’s bought for income (which it delivers).
But it’s more than discounting the future. Lower interest rates benefit high-yield stocks’ capital structure.
Most high-yield investments – REITs, business development companies (BDCs), and master limited partnerships (MLPs) – rely on debt financing. When interest rates fall, so do borrowing costs. Interest expense consumes less cash flow. This enhances the dividend-growth prospects.
And if a high-yield investment of the sort I’ve referenced needs to tap the equity market, it’s best to do so when its shares command a higher price. The price will typically rise when investors anticipate falling interest rates. That’s the time to issue new equity.
The interest-rate backdrop points to a sustained rally in high-yield investments I mention. Gladstone Commercial is one high-yield opportunity to exploit the backdrop. You can find many more opportunities – REITs, BDCs, MLPs, and otherwise – at High Yield Wealth.