Some stocks are more exposed to changes to interest rates than others. Every day that the 10-year U.S. Treasury rises, for example, yield-intensive REITs such as Realty Income take a dip.
Buying and leasing real estate is all about the spread between borrowing costs and leasing revenue. When rates head higher, profits dwindle -- and REITs look less appealing to dividend investors.
But not all dividend stocks are doomed if Federal Reserve chief Ben Bernanke cuts back on quantitative easing. Here are two stocks that could pop on a sudden increase in interest rates.
An interest-rate prospector
Prospect Capital (NASDAQ:PSEC) isn't your average stock. This business development company makes debt and equity investments in middle-market companies that are too small to raise capital on Wall Street. Prospect specializes in financing companies that generate between $5 million and $100 million in earnings before interest, taxes, depreciation, and amortization, or EBITDA.
BDCs should be among the hardest-hit stocks if rates jump, since they lend to high-risk borrowers and buy very illiquid securities. But Prospect Capital is different. Its managers have prepared for a rising rate environment by investing primarily in floating rate debt.
Roughly 85% of its loan portfolio floats up or down with interest rates. Some 75% of the portfolio is first-lien, secured debt, making it first to collect should its portfolio companies go under. In the nearly six years since the financial crisis, Prospect Capital hasn't experienced a single non-payment on any of its loans.
Its investments are just one side of the equation, however. The company uses leverage to juice returns, borrowing low to lend high. All of the company's liabilities are of the fixed-rate variety, meaning any uptick in rates will benefit it at the top line and add nothing to its funding expenses.
Prospect Capital is a great dividend stock for a rising rate environment. Its $0.11 monthly dividend gives the stock a yield of 12%. Investors shouldn't expect significant capital gains, but higher rates could lead to substantial dividend increases, perhaps to the tune of 20% or more over the coming years.
A Bernanke-resistant broker
Higher interest rates in the United States and around the globe will undoubtedly prompt new trading volume in U.S. Treasuries, interest-rate swaps, and other products that center on all things rate-related.
Financial-services company BGC Partners (NASDAQ:BGCP) offers brokerage services ranging from opaque financial derivatives to commercial real estate. The company's core business deals in rates trading, which generated 29.4% of distributable revenue in the second quarter of 2013.
BGC Partners doesn't necessarily make money from a rate increase. Instead, it makes money from volatility and uncertainty. When the markets worry about Fed action, deal-making in interest-rate swaps (products that allow borrowers and lenders to swap rate risk with another party) becomes fantastically profitable as volumes spike.
Rates and foreign exchange trading have offered the biggest profit margin of BGC's trading business. The company's foreign exchange segment picked up after a 2012 slump, rising 14% year over year.
The company pays an impressive quarterly dividend of $0.12 per share, giving BGC Partners a yield of 8% at the current price. Investors should watch the company's reported distributable earnings, which is the basis of its quarterly dividend. BGC Partners frequently pays out more than 100% of its bottom-line GAAP income to shareholders.
Rising rates aren't the end of dividend-paying stocks. High-yielding Prospect Capital and BGC Partners are compelling ideas for investors who want investments with positive exposure to rate hikes.
Fool contributor Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.