The self-styled philosopher kings and occupants of the Eccles Building – the Federal Reserve governors – have divined that easy money should be somewhat less easy.
Over the next eight months, the dials on quantitative easing will gradually be turned down and finally clicked off by the end of the year. By July 2015, interest rates will “officially” rise when the Fed lifts the federal funds rate from zero to somewhere north of zero.
Of course, this is all tentative and subject to change, as are all bureaucratic proclamations. Nevertheless, the equivocating, evasive, fine-print language of the newest Fed ringmaster, Janet Yellen, has most investors anticipating rising interest rates.
This anticipation, in turn, has inspired one of the more frequent questions we encounter at High Yield Wealth these days: “How will rising interest rates impact dividend stocks?”
I wish I could offer a definitive answer; I can’t. Stocks are heterogeneous. A multitude of variables influence an individual company’s value and dividend payout. That said, we can game which dividend payers might benefit and which might suffer in a higher interest-rate environment.
First, we need to consider that rising interest rates are a mixed blessing.
Rising interest rates are frequently a by-product of rising economic growth. At the same time, rising interest rates raise the cost of debt capital. The surge in share buybacks in recent years has been fueled in large part by cheap debt. When rates begin to rise, I expect to see fewer buybacks, which will weaken price support for some stocks.
Fortunately, a growing economy supersedes low-borrowing costs in the grand scheme of things. Economic growth is an obvious plus for the overall stock market. But not everyone will benefit: some stocks will outperform; others will lag.
Many technology stocks will win. Tech companies tend to carry low debt load and a stable fixed-capital structure. This paradigm frequently leads to widening margins when sales accelerate. It also leads to rising dividends. 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 expected to generate winners in a rising-rate environment. But again not everyone will win.
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. But 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 outperform dividend nonpayers by over 17 percentage points.
As for potential laggards, keep an eye on sectors marked by high debt.
Utilities carry a lot of debt, and interest-rate worries weigh on their share price. Master limited partnerships (MLP) carry high debt and could suffer if they need to refinance in a higher-rate environment. Investors also need to keep an eye on their REIT investments, particularly if they own mortgage REITs, which are heavily leveraged and carry interest-rate-sensitive assets.
Surprisingly, though, many REITs actually outperform when 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.
The High Yield Wealth portfolio comprises dividend growers, business development companies, tech stocks – all of which conventional wisdom expects to outperform when rates rise. It also continues to hold energy MLPs and non-mortgage REITs, which conventional wisdom expects to underperform, though which we expect to perform. I say that because individual security is key, whether interest rates are rising, falling, or standing pat.
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