Don't look now, but the free ride is almost over for investors!
For years the Federal Reserve has arguably been more accommodative than it has been at any other point in its long history. Over the last few years the Fed has targeted a federal funds rate of 0.25%, leading to record-low 30-year mortgage rates that have held below 5% for more than three years.
The end result has been a robust rebound in the housing sector, improved personal and commercial demand for loans -- which, on the business side of things, led to steady nonfarm payroll expansion -- and the ability for businesses and consumers to refinance their debts at more favorable rates.
The free ride is nearly over
But we all knew interest rates couldn't stay near their historic lows forever. We also knew that the Federal Reserve's monetary stimulus program known as QE3 -- which involved purchasing long-term U.S. Treasury bonds to push down yields (remember, bond prices and bond yields have an inverse relationship, so purchasing bonds should work to push yields lower) and buying mortgage-backed securities to stabilize the housing sector -- would eventually come to an end.
Given the Fed's latest commentary via its last meeting minutes, it would appear that the Federal Open Market Committee is on pace to end QE3 by October and could be on pace to boost the federal funds rate from its historic lows in early to mid-2015.
The move itself is a bit of a push-pull for investors.
On one hand, the end of QE3 signifies that the U.S. economy no longer needs its training wheels and has decisively put the Great Recession in the rearview mirror.
Conversely, higher interest rates aren't normally welcome. As the federal funds rate rises, other lending rates are likely to follow, including mortgage rates and potentially credit card APRs. In other words, this means consumers who are taking out new loans or who have variable-interest-rate debt could be primed to see their interest owed shoot higher.
Higher interest rates can also discourage businesses from expanding. The current low-interest-rate environment has made it attractive for businesses to take on long-term debt to hire new workers, buy new equipment, or even make acquisitions. As rates rise, the likelihood that businesses will take on fresh debt as readily as they do now is low, in my opinion. The potential here is for slower jobs growth and possibly a slowdown in U.S. GDP growth.
Of course, while homebuilders and other interest-sensitive, high-priced producers are nervously biting their nails, a number of investments sit on the precipice of brighter days. Highly risk-averse investors who prefer bank CDs and bonds are likely to see higher rates of return, which should make those investors happy. In turn, banks themselves are likely champing at the bit waiting for rates to rise so their net interest margin and interest income shoots higher.
Don't make this mistake
While bonds and CDs are instant beneficiaries of rising rates, they aren't where I'd suggest you focus, even if you're a scaredy-cat investor. Bonds and CDs -- and even precious metals, for that matter -- have a number of external factors (e.g., monetary policy from the Federal Reserve or fiscal policy from the government) that can alter their real-money return for investors and actually result in real-money losses when inflation is considered.
Instead of being wooed back to CDs with a 2% yield, I suggest you avoid the mistake of abandoning your dividend stocks as interest rates rise and instead stay the course with businesses that are cash cows.
There are a number of reasons why dividend stocks should always have a place in your portfolio, but the best reason I can surmise relates to demand. Unlike CDs and bonds, which can be affected by external factors that can wipe out your chance of real-money gains, high-quality dividend-paying stocks allow you to invest in businesses that are seeing a genuine increase in demand for their products or services over time -- meaning monetary and fiscal policy are unlikely to have a large material impact on the ability of good companies to grow over time.
Perhaps the hardest thing for an individual to do is to weed out the best businesses from the rest. According to Finviz, out of the thousands of stocks traded in the U.S. with market capitalizations of more than $300 million, there are more than 1,900 stocks that either pay a regular dividend or at least have issued a special dividend within the past year. This makes it difficult to find solid dividend-paying businesses.
Tricks to finding a dividend-paying needle in the haystack
The good news is there are some handy tricks you can deploy to make your search for top-notch dividends easier.
First, consider turning your focus toward basic-needs stocks. Basic-needs companies supply a good or service that remains in fairly constant demand regardless of whether the U.S. economy is growing or contracting. For example, we all need detergent to wash our clothes, food to eat, and electricity for our homes. These are goods and services whose demand rarely drops and actually tend to rise as the world's population grows. Because demand from consumers rarely falls, it means there's little to no incentive for basic-needs companies to discount their goods or services, resulting in highly predictable cash flow, impressive pricing power, and thus organic profit growth. Basic-needs stocks give investors the opportunity to prosper from stock price appreciation as well as a dividend, which is not something you'll get by owning a bank CD.
If basic-needs stocks don't do it for you, then perhaps brand-name businesses will fit the bill. Companies that are globally recognized and have a diverse product portfolio can serve as an anchor for your portfolio even in high-lending-rate environments.
If you need a solid example, look no further than Coca-Cola. The Coca-Cola logo is recognized by 94% of the world's population, the company has more than a dozen beverages that bring in more than $1 billion in annual sales each, and it operates in more than 200 countries. Oh, yeah, and one more thing: If you tried a new Coca-Cola beverage every day it would take you more than nine years to try them all. Talk about diversity and emotionally engaged consumers. That's a perfect reason to consider a company like Coca-Cola, or any other big brand name, as a viable investment opportunity in a rising-rate environment.
Finally, investors can focus their efforts almost entirely on dividends if they'd like by weeding through a growing number of real estate investment trusts. A real estate investment trust, or REIT, is a business that's exempt from standard corporate taxation. In return for not having to pay exorbitant taxes, REITs are required to return at least 90% of their profits to shareholders in the form of a dividend. It's not uncommon for REITs to have dividend yields that surpass 30-year U.S. Treasury bond yields and the rate of inflation, meaning investors are seeing a positive real rate of return. In addition, being an owner in a well-run REIT affords investors the chance to see share price appreciation over time as well.
I should, of course, offer a word of caution that not all REITs are created equally, and if a yield looks too good to be true, it just might be. But REITs are a great place to start your search if you crave a monthly payout or simply a high-yield dividend.