Will Rising Interest Rates Hurt Dividend Stocks?

Will rising interest rates hurt dividend stocks? Many income investors are asking themselves that question as it finally appears 2015 could be the year of higher interest rates. Many so-called “experts” expect the U.S. Federal Reserve to raise key interest rates by the end of the year. The last time the Federal Reserve raised rates was prior to the global financial crisis in June 2006. As you can see below, the federal funds rate, which is the rate at which the Fed’s member banks lend to one another, has been kept near 0% since the financial crisis, a level unseen in the prior 50+ years of US history. In reality, investors really haven’t dealt with persistent interest rate gains for more than 30 years as the long-term trend has been down since the early 1980s.

Not surprisingly, the financial media is buzzing with headlines about when the Fed will raise the federal funds rate and what it might mean for bonds, stocks, and just about everything else. We believe it is dangerous to put much weight into what the “talking heads” say and write. The media exists to drive clicks, TV ratings, and advertising dollars, not to serve your best interests as an individual dividend investor.

As dividend investors, the thought of rising interest rates generates an easy fear to latch onto – with higher rates becoming available in other asset classes, will my dividend holdings drastically underperform in future years as investors trade for yield elsewhere? Which of my dividend stocks are most vulnerable? Should I hold onto my utilities, telecoms, and REITs?

Everyone wants a simple, clear answer. But the world doesn’t work that way, and neither do markets. In the near-term (i.e. periods defined in years, not decades), anything can happen. What’s most important, as you will see from the following data, is that you know your long-term investing goals and stick with your strategy to meet them. Whether interest rates rise gradually or rapidly in coming years or remain near zero, we believe it is far more important to remember that you own part of real businesses that you believe will continue growing their cash flows and paying increasingly higher dividends far into the future. Whether interest rates take off or not, these types of investments will win over the long haul.

With that said, let’s look at how dividend stocks have fared during past periods of rising interest rates, which are not necessarily representative of today’s market environment but at least reinforce the importance of long-term thinking and staying the course.

How Rising Interest Rates Have Impacted Dividend Stocks

The following images are from a presentation we recently viewed by Santa Barbara Asset Management. We won’t save the best for last in this post – we will come out guns blazing with the following chart, which shows how dividend payers have performed over the three years after the Fed increased rates every time since 1972.

You will notice that the first few months immediately following a rate increase were marked with volatility and underperformance. Within one year, however, dividend payers who did not cut their dividends during the period had completely recovered and were well on their way to continued gains over the next two years. Dividend growers outperformed all other types of stocks in the data, reinforcing what we already know – find high quality dividend growth stocks trading at reasonable prices and hold onto them as long as possible (barring any extreme changes in valuation or fundamentals). These qualities matter much more to an investment’s long-term performance than a moderate change in interest rates.

We mentioned that the first few months after a rate increase were historically marked by volatility in the market. We have already witnessed plenty of volatility over the last month, but more could be on its way in coming months. Do not panic. Do not think that volatility in your dividend portfolio means that your higher-yielding holdings are now doomed.

If anything, let the volatility create opportunities for you to put more capital to work at even more attractive reward-to-risk ratios. As seen below, dividend growers have significantly outperformed the market during periods of elevated volatility, as measured by the VIX.

Not all volatility is created equal. No one knows if the potential volatility caused by an increase in the Federal funds rate will cause results to differ from the table above. However, over longer periods of time, even those marked by rising interest rates, the importance of dividends to the market’s overall total return has remained consistent. We can see that dividends continued to account for a large portion of the market’s total return even during past decades of rising interest rates (e.g. 1950 through 1980):

Some pot-stirrers will talk about a “dividend bubble” that has been caused by zero percent interest rates over the last six years. We agree that certain low volatility dividend payers have been increasingly viewed and valued as debt by some equity investors, which works against future total returns for those stocks. However, as seen below, US dividend yields are about in line with their 20-year average. If dividend stocks were truly bubbly, we would expect to see the green circle (dividend yield as of 12/31/14) well below the gold line (20-year average):

Hopefully by now you realize that (1) the months surrounding a rate increase could be marked by increased volatility and, yes, certain dividend stocks could underperform by a modest margin; (2) within 6-12 months of a rate increase, and especially over the following years, the characteristics of quality dividend growth companies are likely to make them winning investments; and (3) don’t let the talking heads on CNBC deter you from your long-term investing strategies as their chatter about rates picks up – they don’t know the future any better than you do, and their time horizon is a fraction of what yours should be.

The Impact of Rising Interest Rates on Personal Finances

In a future post, we will explore the industries and types of companies that would benefit from a (gradual) return to a normalized interest rate environment. First, the following charts might provide the kick you need to improve your personal finances while rates remain extremely favorable (or maybe they stay low for much longer than many expect, who really knows). If rates do start to increase over coming years and decades, some of these opportunities will probably be viewed later as once-in-a-generation moments.

Are you thinking about getting a new car? Or, as my family likes to say, a car that’s at least new to me? I don’t like debt, but financing rates are unbelievably low right now for automobile purchases. Many dealerships are extending loan terms beyond five years, but the chart below shows the interest rate on 48-month auto loans. As you can see, financing rates are the lowest they have been in more than 40 years and currently sit below 5%.

If you have a new car, hopefully you have a garage to store it in.  If you own your garage and have an outstanding mortgage on your property, hopefully you have already refinanced over the last few years. If you haven’t yet, the following chart might give you a nudge to pick up the phone. The average 30-year fixed rate mortgage rate is 3.9% today, again the lowest rate in more than 40 years (excluding the drop in 2012).

Time for our least favorite type of debt – credit cards. While not as much data exists on credit cards because they haven’t been around as long as cars and home mortgages, we can see that the average interest rate on credit card plans is the lowest it has ever been at about 12%. If you know your own credit history and credit score, CreditCards.com reports that while relatively few ask, two out of three cardholders who ask for a lower rate get it. Alternatively, if you are carrying a balance, are you prepared and able to pay higher interest if rates begin to rise?

In a future post, we will analyze specific industries and stocks that are frequently discussed when the topic of interest rates comes up – utilities, REITs, high-yield low-growth stocks, and more.

Until then, remember your long-term plan, continue hunting for the best dividend growth stocks, and listen to a little less financial news!