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

Buying a House: Part III – Buying Tips

Before you go shopping get pre-approved for a mortgage. Add your down payment to the mortgage amount and now you have a maximum budget that you can spend.

Step One: Neighbourhoods

Where would you like to live? Measure your commute time to work and access to public transportation. Living outside of a big urban centre may allow you buy a bigger house for less money. Check out what is important to you like; access to schools, shopping, parks/playgrounds, day care, doctor/dentist, hospitals and closeness to family & friends.

Step Two: Type of House

Look at your lifestyle; will you be happy in a condo, townhouse, semi-detached or detached house. What features are important to you (size of living space, number of bedrooms, bathrooms …etc.)? Are you willing to roll up your sleeves and buy a fixer upper or do you prefer new?

Step Three: Get some help

Find an experienced real estate agent. Hire a lawyer to look after legal issues and review contracts. Hire a home inspector if you plan on buying a resale. Look at the recent selling price of properties that have been sold in the area. Talk to friends and relatives regarding their house buying experiences.

Step four: Make a checklist

  • How old is the house
  • In-law apartment or potential rental space
  • Lot size, back yard, patio, deck
  • Is it on a quiet street
  • Updated kitchen & washrooms
  • Exterior finish – brick, stucco, aluminium siding, wood siding
  • Type of heating – oil, natural gas, electric
  • Has plumbing & electrical been updated
  • Air conditioning, alarm system, wood or gas fireplace
  • Private or shared driveway, garage or carport
  • Unfinished or finished basement
  • New roof or needs replacing

Step Five: Avoid Paying Too Much

Bidding wars on the same property can be fabricated. The listing price is set below market. The rooms are painted in a light or natural colour and furniture has been removed to make the rooms look bigger. A good real estate agent will know if the house is listed below market. Be patient, wait for the right house and buy for the right price.

Buying a House: Part II – Down Payment

Based on my last blog, you should have a rough idea of what you can afford. Now can you save the required down payment to purchase your first house? Boosting your savings rate from 10% to 15% of your gross family income will give you a better chance of achieving your goal.

Don’t forget about closing costs! Multiply 3% of the house price for lawyer fees, house insurance, title insurance and land transfer tax. Depending on your closing date you may need to pay some pre-paid expenses like property taxes.

To reach your savings goal, I strongly recommend a forced saving plan. Allocate a set amount of your weekly or bi-weekly pay check into a RRSP to take advantage of the first time “Home Buyers’ Plan”!

Advantages

  • Tax free personal withdrawal of $25,000 ($50,000 per couple)
  • Interest free loan
  • Refunds can be added to your saving plan
  • You have 15 years to repay the withdrawals
  • Income on investments grows tax free
  • No withholding tax on withdrawals

Disadvantages

  • Your retirement plan will lose income
  • A missed repayment will be added to your income
  • Must make an annual repayment of 1/15 of the withdrawal

Check out the CRA web site to see if you qualify as a first time home buyer. Plus have a good look at their withdrawal and pay back conditions. Contributing $50,000 over time into RRSPs could result in adding another $10,000 to $15,000 to your down payment.

Saving for a down payment can be reachable. It would only take three years to save $25,000 by transferring $700 a month into your RRSP. Save the refund and a couple could have $65,000 for a down payment.

Don’t wait to find your soul mate, start saving now, so that you and your soul mate will have someplace to live.

Buying a House: Part I – Affordability

The first step in house buying is figuring out how much house can you afford. The calculation depends on your family income, borrowing costs, the size of the down payment and your monthly debt payments.

Affordability Rule 1

The first rule is that your monthly housing costs shouldn’t be more than 32% of your gross monthly income. Housing costs include your monthly mortgage payments (principal and interest), property taxes and heating expenses. This is known as PITH for short — Principal, Interest, Taxes and Heating ( if buying a condo, include half of the monthly condo fees)

Affordability Rule 2

The second rule is that your entire monthly debt load should not be more than 40% of your gross monthly income. Your entire monthly debt load includes your housing costs (PITH) plus all your other debt payments (car loans or leases, credit card payments, lines of credit payments, student loans etc.). You have calculated these on the Monthly Debt Payments form. This figure is called your Total Debt Service (TDS) ratio.

Types of Mortgages

1. Conventional mortgage – requires a minimum down payment of 20% of the purchase price. The maximum amortization period is 30 years. Terms vary from one to five years and the interest rate can either be fixed or variable. (open mortgages are also available)

2. High ratio mortgage (less than 20% down) – is insured with the Canadian Housing and Mortgage Corporation. (CHMC) The insurance cost is based upon the amount of the down payment. The minimum down payment required is 5% of the purchase price and will cost the borrower about 3% to 3.5% of the value of the mortgage. The cost is added to the mortgage and the maximum amortization period is 25 years.

3. Secured line of credit – requires a minimum 35% down payment of the purchase price and requires a monthly payment equal to the interest charges.

Go on-line and google “How much house can I afford calculator”. Put in different amounts for down payment and try changing mortgage interest rates and amortization.

Here is one example: Using a RBC calculator

Total Family Income      $90,000.00       90,000.00
Total Debt              $0.00              $0.00
Monthly Mortgage Payment        $1,900.00         1,800.00
Interest Rate             3.50%             3.50%
Property Taxes / monthly             350.00           450.00
Heating Costs / monthly            150.00           150.00
Total Monthly housing cost        $2,400.00       $2,400.00
Down Payment           10.22%           20.33%
Dollar Amount       $42,000.00      $92,000.00
Mortgage Principal amount     $368,934.00      360,526.00
Default Insurance = 2.83%       $11,621.00              $0.00
Total Mortgage amount     $380,555.00     360,526.00
Amortization           25 years          30 years
Maximum Purchase price     $410,934.00     452,556.00

This example also illustrates that the cost of a high ratio mortgage can be expensive. It will take about 15 monthly mortgage payments to pay off the default insurance of $11,621 that was added to the mortgage total. I would be very careful when borrowing money to finance a house. You don’t want to be house poor, where you cannot afford other things in life.

Now you should establish a savings goal to buy your house.