While the financial media fawns over new records being set by the Dow… one important story has fallen through the cracks.
And it could have dire consequences on your investment income.
Interest rates. They’ve been steadily rising for the last month. Rates on 10-year U.S. Treasuries have risen from 1.66% to 2.13% yesterday.
Now that may seem like a small move of roughly ½ percent. But on a percentage basis, it’s a whopping 28% increase. Even if you haven’t noticed this move, it’s significant…and it’s been more than enough to lure some foolhardy investors to buy bonds.
The comments from our esteemed Federal Reserve Chairman Ben Bernanke are sending interest rates higher.
Earlier this month, Bernanke hinted that the Fed could slow its $85 billion per month bond buying program. The timing of changes remains uncertain.
But the key point is that the Fed is prepared to cut back on bond purchases if the U.S. economy continues to improve. With home prices rebounding, unemployment trending down and the stock market at record highs, Bernanke is now considering taking his foot off the gas.
In many ways, any slowdown in Fed bond purchases will signal a better outlook for the economy. And this changing environment obviously has some implications for income investors.
When the Fed slows its bond purchases, interest rates on Treasuries will start rising. And it’s already started with just a mere hint that this might happen.
As a rule of thumb, bond prices fall when interest rates rise. And that’s what’s happening today. In fact, during May the iShares ETF tracking 7-10 year U.S. Treasuries fell more than 3%, while the 20-year tracking ETF dropped more than 7%.
Investors in bonds are suffering some small initial losses already. If interest rates continue rising, bondholders could face considerable principle losses.
Rising interest rates similarly affect dividend stocks. If yields on Treasuries improve considerably, income investors may be tempted to allocate more cash to bonds. And this would result in selling pressure on dividend stocks.
For example, on Wednesday Treasury yields rose to a one-year high. That rise sparked some selling of dividend stocks, as the iShares Dividend Index (NYSE: DVY) – an ETF of dividend stocks – fell 1.3% for the day. That drop nearly doubled the decline in the broader market.
But one day doesn’t define a new trend. In fact, it appears this week’s decline in dividend stocks was short-lived.
While it may seem counterintuitive, weaker economic data sent stocks rising yesterday. Weekly unemployment rose slightly, and first quarter GDP growth of 2.4% was just shy of estimates.
This seemingly negative economic news could mean that the Fed’s bond buying program will continue undisturbed for months to come. And that’s good news for investors who are long stocks, especially dividend stocks.
It appears that the best thing for the stock market is a slow and steady economic recovery. That’s exactly what’s been happening since 2009. And there is little evidence that the pace of economic recovery will change anytime soon.
Looking at the big picture, dividend stocks will continue to dominate. Reasonable valuations and a higher yield than the 10-year Treasury makes stocks a better bet for total return over the coming years.
Some investors may be enticed to buy bonds by the rising interest rates. But you and I know better…now is the time to stay the course, keep buying dividend stocks, and continue collecting more income for years to come.