Federal Reserve officials will meet again on June 12. The meeting will likely end with another interest-rate increase.
The federal funds rate is the interest the Fed will increase. The fed funds rate is the overnight lending rate among commercial banks. It is the base rate for all other interest rates.
The Fed has increased the fed funds rate six times since December 2015. The last increase occurred in April. The next increase will likely occur this month. Traders in fed funds futures contracts are giving high odds. They bet there’s a 90% chance the Fed will raise the fed funds rate this month.
Rising Interest Rates and Stocks
So, how do rising interest rates affect your stock portfolio? The answer is, it depends.
If interest rates rise with an improving economic outlook, stocks with economically sensitive cash flows tend to outperform most stocks. Non-dividend-paying growth stocks represent this segment. Facebook (NASDAQ: FB), Alphabet (NASDAQ: GOOGL), and Netflix (NASDAQ: NFLX) are ready examples.
As for dividend stocks, moderation is a worthy attribute. Moderate-yield dividend growers have more stable cash flows than their non-dividend-paying counterparts. Their cash flows are less sensitive to the vagaries of the economy.
The “moderate” segment is represented by companies like McDonald’s (NYSE: MCD), Microsoft (NASDAQ: MSFT), and VF Corp. (NYSE: VFC). These established dividend growers historically plugged along when faced with rising interest rates. This is understandable. The rising dividend compensates investor demand for more income.
As for high-yield dividend stocks (BDC, MLPs, and REITs), they tend to underperform. Because cash flow is constant, many high-yield dividend stocks are unable to offset rising financing costs. They’re also unable to meet investor demand for higher income yield.
These high-yield-dividend stocks are frequently perceived as bond surrogates. They’re more likely to suffer when interest rates rise. A simple example explains why:
If you own an investment that pays $100 annually, you’d be willing to pay $2,000 for the investment if long-term interest rates are 5%. (The value is calculated by dividing $100 by 0.05.)
If long-term interest rates rise to 10%, you’d be willing to pay a lot less. You would be willing pay only $1,000 for the same investment. (The value is $100 divided by 0.10.)
But don’t toss in the towel on your high-yield-dividend stocks. Stocks aren’t bonds. Many high-yield-dividend stocks can compensate investors when faced with rising interest rates.
REITs are popular high-yield-dividend stocks. Many listed equity REITs increase in value in a rising-interest-rate environment. Listed equity REITs actually posted a cumulative total return of nearly 80% when the Fed raised its target for short-term interest rates to 5.25% from 1% in 2004 through 2006. Equity REITs outperform the S&P 500 over the period.
Stock Selection is Key
Selection matters. It always does. Look to REITs with low leverage and low exposure to interest rate increases. These REITs should continue to post solid operating performance as interest rates move higher. Iron Mountain (NYSE: IRM) is a worthy example of such a REIT.
Other high-yield-dividend stocks can prosper as well. Some, like Ares Capital (NASDAQ: ARCC), carry variable-rate debt on the asset side of the balance sheet. These debt investments are financed with fixed-rate debt. When interest rates rise, income from variable-rate debt rises while the liability side remains constant. Voila, more net-interest income for the BDC.
Rising interest rates can affect your stock portfolio for better or for worse. Stock selection is key. If you have selected correctly, your best course of action is to stay the established course.