Will they or won’t they?
I refer to the board of governors at the Federal Reserve. Will they finally move to raise interest rates in 2015?
It might not matter. On Wednesday, I presented my thesis that explains why Fed officials are unable to raise interest rates, even if they want to. In short, the Fed unwittingly relinquished interest rate control when it embraced quantitative easing.
This isn’t to say interest rates can’t rise. Indeed, rates have been on the rise with no push from the Fed. In the past month, the 10-year U.S. Treasury note is up 35 basis points and is at a year-to-date high.
A rise in interest rates leads to a rise in the frequency of a recurrent income question: “How will rising interest rates impact dividend-paying stocks?”
Everyone who asks wants a definitive answer. I wish I had one. But I don’t, and neither does anyone else.
Stocks are heterogeneous. A multitude of variables influence an individual company’s value and dividend payout. That said, I can generalize by type.
First, we need to consider that rising interest rates are a mixed blessing. Rising interest rates are a byproduct of rising economic growth. At the same time, rising interest rates raise the cost of debt capital. Some dividend payers will win; some will lose.
Technology stocks can be slotted into the winners category. Tech companies tend to carry low debt loads and have stable fixed-capital structures. Rising economic growth 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 segment expected to generate winners in a rising rate environment. But 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 outperformed dividend nonpayers by over 17 percentage points.
As for potential losers, 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 (MLPs) carry high debt and could suffer if they need to refinance in a higher-rate environment.
Surprisingly, many real estate investment trusts (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 deliver 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 and tech stocks – all of which conventional wisdom expects to outperform when rates rise.
The portfolio also continues to hold energy MLPs and non-mortgage REITs, which conventional wisdom expects to underperform, though which we expect to outperform. I say that because individual security is key, whether interest rates are rising, falling, or standing pat.
Dividends for Every Month of the Year
If you’re looking for just one dividend stock to round out your income stream, consider a little-known company that pays out dividends 12 months of the year.
Click here to see the full details of this company in my Dividend Calendar…