Dividend Paying Stocks and Rising Interest Rates

Ever since the Federal Reserve Bank started to retreat from easy money policies (“tapering of quantitative easing”), speculation has risen as to the impact on stock portfolios. Is undue concern warranted?

 With interest rates on traditional safe money assets still at low levels with negative returns adjusted for inflation and taxation, investors have sought refuge in a variety of asset classes, including high dividend paying stocks. On January 8, 2014, USA Today headlined, “10-Year Treasury yield jumps back up to 3%.” By way of contrast, in September 2011 the headlines centered on the benchmark 10-year Treasury note approaching a six decade low of 1.91%.

 Since that low, strategists have feared rising rates, suggesting that investors reconsider portfolios in vogue when yields were declining and safety was in high demand. One pundit, writing in a major financial journal in January 2014 midst the rate surge to over 3%, said that it may be time to ditch high income sectors such as utilities in favor of companies that can increase earnings as the economy picks up steam.

 A funny thing happened on the way to “full steam ahead.” At the end of April 2014 the 10-year Treasury rate was 2.66%, and the economy is not exactly roaring. The 30-year Treasury bond hit a 2014 high of 3.97% in January. Yields on the 30-year bond dropped to 3.44% on April 25, 2014, the lowest level since July 2013.

 Heightened international tensions over Russia and Ukraine have driven investors to a safe haven in U.S. Government securities. When demand pushes up prices, yields fall. “Safety” is not out of style.

 Changes in interest rates are quoted in “basis points.” A basis point is 1/100th of 1%; a hundred basis points equals 1%. Basis points are applied to calculate changes in interest rates, equity indexes, and the yield on a bond or other fixed income instrument. One-percent does not sound like much, but a 100 basis point move in the fixed income world is huge.

 There have been seven sustained periods of rising U.S. Treasury rates between December 1982 and December 2013. The shortest duration of a rising rate cycle was 9 months; the longest, 36 months. The average duration of the up move was 17.1 months. The highest absolute change in rates was plus 3.45% (345 basis points) over 18 months starting in December 2012. So far the smallest absolute increase was 1.40% September 2012 through December 2013. The average increase over the past seven cycles was 2.13%.

  Fixed income, represented by the Citi 10-year Treasury Index, had negative returns in 5 of the 7 cycles, with an average loss of -4.82%. In 3 of the cycles the loss exceeded 8%. The Dow Jones Utilities Index showed positive returns in 5 of the 7 cycles, and losses in 2 cycles. The S&P 500 Index was positive in all 7 cycles.

 Economic data and the historical average slope of the yield curve suggests that 10 to 30 year Treasuries should yield between 3% and 4%. The new head of the Federal Reserve Bank, Janet Yellen, has taken a measured course, assuring markets that interest rates will stay at reasonably low levels for the foreseeable future. Inflation is relatively restrained, notwithstanding recent jumps in gas and food prices. CPI-U All Items inflation is up +1.5% March 2013-March 2014.

 We are not looking for interest rates to follow an inflationary surge anytime soon. Absent a sudden price shock like the 1974 oil embargo, increases in inflation rates are expected to be gradual.

  What kind of portfolio is likely to hold up best in a rising rate environment? While past results cannot be used to predict future results, certain strategies have proven valuable in defending portfolios: a focus on companies with earnings largely from non-discretionary products and services which favor the ability to raise future dividends. Stocks with the potential for rising dividends would feature real assets that comprise the operating infrastructure of our economy, including the energy sector, a hedge against inflation.

 Rising dividends are a strong component of total return and an alternative to bonds with a fixed rate of return.

 Lewis Walker is President of Walker Capital Management LLC. Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies. ▪ 3930 East Jones Bridge Road ▪ Suite 150 ▪ Peachtree Corners, GA 30092  ▪ 770-441-2603 ▪ lewisw@theinvestmentcoach.com