How Will Dividend Stocks be Effected by Rising Interest Rates?

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Today’s blog post was a suggestion from another blogger “Fumbled Returns”, you can find him at Bear with the Bull. He asks a very interesting question, for the record, not all dividend stocks are alike. There are a multitude of variables that influence the value of a dividend stock and their dividend payout.

That being said, raising interest rates are a big factor in causing the average investor to adopt a negative view on dividend stocks. They tend not to distinguish between the good and the really bad dividend stocks. In the past, many of my good quality dividend stocks have been trampled by the herd of sacred investors running to the exits.

Utilities carry a lot of debt and interest rate worries weigh heavily on their share price. Power generators and pipeline companies require large sums of funds in order to expand their growth. Many utilities can’t raise prices immediately if their interest costs go up, plus higher borrowing costs could delay projects or make certain projects under construction less profitable. Just the mere mention of the possibility of a rate hike by the Fed in 2015 has already reduce the value of utility stocks by 10% since the beginning of February. Below is the year-to-date chart of the utilities ETF (XLU)

utility

 

Telecommunication companies require a lot of debt financing in order to expand or upgrade their networks. They are typically slow profit growers so the majority of investors buy these stocks for the dividend yield. Telecommunication companies have to compete with long-term bond rates in order to attract investors. Verizon Communication looks attractive with a 4.5% dividend yield when the 10 year bond yield is under 2% but less so if the bond yield goes back to the 4% level.

Real Estate Investment Trusts (REITs) is another sector that carries a lot of debt and higher borrowing costs could affect their ability to expand their holdings. However, raising interest rates are also an indication of strong economic growth which allows Reits to raise rents and reduce vacancy rates of their rental units. Another factor that investors sometimes miss is that Reits have long-term mortgages which are staggered so they don’t all come due at the same time. I have picked up some real bargains once the herd has run to the exits.

High yielding Master Limited Partnerships (MLPs) in real estate mortgages is an area that investors should head for hills in a raising interest rate environment. These are highly leveraged partnerships with dividend yields over 12% which look extremely attractive today but are very risky!!!!

Banking used to be good dividend sector prior to the financial crisis. If long-term rates rise and short-term rates remain near zero, banks that lend long (mortgage lending) and borrow short will benefit. But if short-term rates rise with long-term rates, banks with balance sheets covered with assets sensitive to short-term rates (home-equity loans, credit cards, business lines of credit) could be in trouble.

Commodity stocks will suffer if raising interest rates cause a strengthening of the U.S. dollar. Weaker commodity prices will reduce a company’s revenue and lessens their ability to maintain a dividend payout.

red flag

Warning signs of a possible dividend cut:

  1. Payout ratios of over 100%,
  2. Dividend yields higher than junk bonds
  3. Stocks with higher dividend yields than their competitors
  4. High debt to equity ratios
  5. A long string of quarterly financial losses
  6. A recent cut to dividends

Not all dividend stocks are created equal. Some sectors like consumer staples, health care and technology have relatively low debt levels. They have a tenancy to generate a lot of cash and have a history of increasing their dividends. Raising interest rates will have little effect on their dividend payout. For example; Microsoft has a dividend yield of 2.9% and Pfizer yields 3.3%, in my playbook, their dividends are much safer from a cut than say, American Electric Power yielding 3.8%!

caution Raising interest rates usually causes FEAR levels in investors to surge. Stock values in all sectors could experience a temporary fall in value.

Do you have a question that you would like answered or a suggestion for a blog post? Leave a comment or email me ricodilello@rogers.com

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