Dec. 14, 2016 looms large. It looms large because this is the day everyone expects the Federal Reserve to raise interest rates.
When an interest-rate increase looms, so do investor apprehensions. Investors will sell when the Fed announces an increase in the federal funds rate (the rate that is raised when the Fed raises interest rates). Not only that, investors will sell in anticipation of the event as much as the actual event.
So, why do stocks sell off on an interest-rate increase?
Discounting is one reason. Interest rates are a variable in discounting future cash flows. Value is determined by the future value of company cash flows discounted to the present. Cash flows are discounted to the present by a discounting rate, which comprises a risk-free rate (the federal funds rate serves as a base) and a risk premium. A simple example demonstrates my point.
Let’s say that you have an investment that will pay you $100 annually in perpetuity. If your discount rate is 5%, you’re willing to pay $2,000 for this investment ($100/0.05). If your discount rate rises to 10%, you’re willing to pay only $1,000 for this investment ($100/0.10). Bonds and other debt securities values are determined by this discounting procedure.
Stocks have a few more moving parts than bonds, though. Yes, the present value of future cash flows will fall if interest rates rise, but the cash flows themselves can rise if higher interest rates are correlated with stronger economic growth and improving business prospects. For these reasons, stocks will frequently recover after an interest-rate increase.
The Effects on Dividend Stocks
As for dividend stocks, they’re not all built alike, so they don’t react to an interest-rate increase uniformly.
Dividend-growth stocks are less vulnerable to an interest-rate increase than most. Rising interest rates are correlated with rising economic growth (at least historically). In the go-go 1990s, the federal funds rate doubled over the course of the decade. During that time, S&P 500 stocks – of which dividend growers are a major component – rose 250%.
On the other hand, high-yield equity investments – REITs, BDCs, MLPs – frequently experience more volatility, which is understandable. These investments are imbued with bond-like characteristics. They are valued more for immediate cash flow (to the investor) than for their growth prospects.
Rising interest rates increase high-yield volatility in other ways. REITs, BDCs, and MLPs are pass-through entities: They pass their earnings (and most of their cash flow) onto their investors. The retained earnings pool mostly runs dry. To grow, these entities must either issue new equity or new debt. Rising interest rates raise the cost of both.
The good news is that the volatility abates. As I note above, rising interest rates should be correlated with rising economic activity. The positives of rising economic activity, in turn, can lead to rising revenue that offsets any increase in capital costs.
History shows that share prices of equity REITs (like the High Yield Wealth REIT recommendations) often increase during periods when the Fed shifts from a stimulative policy stance to a neutral one. REITs posted a cumulative total return of nearly 80%, outperforming the S&P 500, when the Fed raised its target for the fed funds rate to 5.25% from 1% in 2004 through 2006.
Embrace the Opportunity
BDCs could perform even better than REITs in a rising-rate environment.
Consider my favorite BDC Ares Capital Corp. (NASDAQ: ARCC) and its 10% yield. Ares Capital’s investment portfolio is composed mostly of floating rate loans; these loans should generate more interest income as rates rise. On the other side of the ledger, its capital base is composed mostly of fixed-rate debt. As rates rise, at least part of the funding costs will hold steady, while the loan portfolio will generate more income.
The transition to a more neutral monetary policy by the Fed will lead to share-price volatility in the short term, particularly in the aforementioned high-yield pass-through investment. But if the recent past is prologue, volatility should be embraced as an opportunity as opposed to being repelled as a course.