Higher Rates Will Hurt These Stocks

After years of staying at unprecedented lows, interest rates have turned around, and they look poised to head higher in the future. Although you may be aware of the potential impact that could have on the portion of your portfolio you have invested in bonds, you may not realize is that some stocks will get hurt by higher rates as well.

On the rise
In recent months, most investors have had their attention squarely focused on the stock market. Stocks have rallied sharply, with more than 25% gains for the S&P 500 since the end of August. The persistence of the rally has surprised many investors, who have expected to be able to take advantage of corrections along the way that so far haven't come.

The trade-off is that several areas of the bond market have sold off in equally dramatic fashion. The yields on 10-year Treasuries have risen by more than a percentage point, quickly jumping from less than 2.5% in August to around 3.6% now. Longer-term 30-year Treasury bonds have seen similar increases, going from around 3.5% to 4.7%.

Those rates have filtered down into areas that affect ordinary people. For example, mortgage rates have risen sharply in the past few months. After hitting lows around 4.2%, rates on 30-year mortgages recently jumped above the 5% level before falling back a bit. Unfortunately for savers, higher rates aren't translating into higher returns on CDs; rates for a one-year term remain stubbornly near the 1% mark.

Where stocks could suffer
For now, higher rates have hurt income investors, but stocks have mostly been left alone. That could change in the near future.

One obvious place to look for damage from higher rates is in the red-hot mortgage REIT industry. American Capital Agency (Nasdaq: AGNC  ) , Chimera Investment (NYSE: CIM  ) , and Annaly Capital (NYSE: NLY  ) have maintained dividend yields above 10% for quite a while, on the back of huge spreads between the long-term rates they earn on mortgage securities they buy and the short-term rates at which they borrow.

Actually, as long as short-term rates stay low -- and for the most part, they have -- then higher long-term rates could actually help Annaly and its peers. But with inflation fears heading up, many are increasingly expecting the Federal Reserve to succumb to pressure to raise short-term rates as well. That would cut the rate spreads that mortgage REITs count on, eventually forcing them to reduce their dividends.

Winners and losers among corporate borrowers
For corporations, higher rates would typically bring an uncomfortable increase in financing costs, pressuring profits. But many companies showed a great deal of foresight in preparing for the eventuality of higher rates, locking in attractive long-term financing while rates were low. Only those that missed out could be in for trouble.

The winners include Johnson & Johnson (NYSE: JNJ  ) , Apache (NYSE: APA  ) , and Moody's (NYSE: MCO  ) , each of which took advantage of last summer's low rates to issue bonds with maturities between 10 and 30 years. Several other blue-chip stocks, including IBM, got rock-bottom rates for shorter-term debt, getting cheaper financing but leaving themselves vulnerable to having to refinance in 2013 at potentially much higher rates.

Even some debt-swamped companies have managed to reduce their debt costs. Last month, MGM Resorts (NYSE: MGM  ) got junk bond financing to refinance its debt, paying 7.625% on one of its issued bonds and 10.75% on the other. But not every debt-swamped company was able to take advantage of low rates recently. And even those companies that could refinance now face a long-term challenge: as rates return to normal, the one-time benefit they got from low rates will end. The inevitable adjustment could be painful for a big group of stocks down the road.

Watch the rates
Higher rates have an obvious impact on fixed-income investments. But even stock investors have to understand the effect that higher rates could have on their portfolios. If you're prepared for the future, you may be able to avoid the problems that end up blindsiding others.

Mortgage REITs aren't the only high-yielding dividend stocks out there. Find the best of the rest in the Fool's free special report, "13 High-Yielding Stocks to Buy Today."

Fool contributor Dan Caplinger is sad to see his old high-rate CDs mature. He owns shares of Chimera Investment. Johnson & Johnson is a Motley Fool Inside Value selection and a Motley Fool Income Investor recommendation. Moody's is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended writing puts on Moody's and a diagonal call position on Johnson & Johnson. The Fool owns shares of Annaly Capital, IBM, and J&J. Motley Fool Alpha owns shares of J&J. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will never hurt you.

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