One of the most highly anticipated economic events of 2015 is the Federal Reserve's long-awaited interest rate increase -- which will be the first since 2006. And while nobody knows exactly when it will happen, interest rates will definitely rise at some point. Here's what you need to know about how rising rates could affect the dividend stocks in your portfolio and what the best course of action is for you as an investor.
Rising rates do have some negative effects
In general, rising rates are thought of as a negative for the stock market, and there are certainly valid reasons for this.
For starters, when interest rates rise, it costs companies more to borrow money. Most publicly traded companies carry at least some debt to fund their operations, and higher borrowing costs can cause their profit margins to contract. To illustrate this, consider that if a company can earn a 10% return on borrowed money and it pays 4% interest on it, the company's profit margin is 6%. If interest rates jump to 5%, the profit margin drops to 5% as a result.
Another potentially negative result of rising interest rates is specific to dividend stocks -- especially those that pay bond-like yields. Stocks are assumed to be riskier investments than bonds, so when the risk-free rate of return increases, investors may be more inclined to sell their stocks and buy assets with guaranteed income streams.
Consider Microsoft, which is a part of many income investors' portfolios and pays a 3.2% dividend yield as of this writing. Well, a 10-year Treasury pays just 2%, so it's easy to understand why an investor might want to accept the risk associated with owning Microsoft stock in order to achieve a higher level of income.
But if the 10-year Treasury yield were to jump to 3% all of a sudden, then it may not make sense to a retiree to accept the risk of owning the stock. In other words, fixed-income investments become more attractive as rates rise, which can create selling pressure on dividend stocks.
... but it's not all bad news
On the other hand, there are some positive aspects of rising rates. Generally, rising interest rates signal a strengthening economy. As the economy gets stronger, companies tend to sell more of their products and also possess more pricing power, leading to higher profits.
Plus, as we'll see in a minute, the negative effect of rising interest rates on borrowed money is actually a positive factor for certain industries.
Some dividend stocks could get crushed
To put it simply, the sectors that are likely to perform poorly as rates rise are those that will be most affected by the negative factors listed above. This includes those that pay steady, bond-like interest rates, as well as those industries and companies that are heavily reliant on borrowed money.
Here are a couple of industries that could perform poorly as rates rise.
Real estate investment trusts (REITs) -- This is especially true for mortgage REITs such as Annaly Capital Management and American Capital Agency. These companies rely heavily on borrowed money, and could see profit margins contract or even become negative if rates increase. Just look at how these companies performed as a result of a rate spike in 2013. Bear in mind, this poor performance occurred in a year during which the S&P 500 gained more than 26%.
Equity REITs (those that own properties) also borrow money and could be hurt by rising borrowing costs. However, many equity REITs maintain relatively low debt levels, but could also face selling pressure as income-seekers flee to "safer" fixed-income assets.
Utilities -- Not only do utilities tend to carry a lot of debt, which can lead to contracting profit margins if rates rise, but utilities generally don't produce much growth and pay out most of their earnings as dividends. In other words, these relatively high dividends are more like bonds in the eyes of income investors, and if bond yields rise to a comparable level, utility stocks seem much less attractive.
And others could thrive when rates rise
As I briefly mentioned earlier, some industries actually benefit from rising interest rates. To name just a few:
- Banks -- Banks that make most of their profits from lending money are in a good position to profit from rising rates. Lenders make their profits from the spread between how much they pay to borrow money and how much interest they can collect when they lend the money to customers. As rates rise, this spread tends to widen. In fact, in its most recent earnings presentation, Bank of America projected that its net interest income could grow by as much as $3.9 billion over the next 12 months as interest rates normalize.
- Insurance companies -- Contrary to the belief of many investors, insurance companies generally don't make much of a profit from the premiums you pay. Instead, they take that premium income and invest it -- profiting from the income generated from these investments while waiting to pay claims. Since insurance companies are highly dependent on their ability to generate interest income (most insurance company investments are fixed-income), rising rates can significantly boost profits.
- Tech stocks -- Generally speaking, tech companies don't carry much debt, and many that do have debt issued it because rates have been low lately. This is especially true of the larger, established dividend-paying tech companies. For example, Apple has more than $47 billion in long-term debt on its balance sheet, but it issued its debt in order to take advantage of record-low interest rates, not because its business depends on borrowed money. Additionally, tech companies stand to benefit from higher sales as the economy improves. As consumers have more disposable income and are more confident in their financial condition, Apple will sell more iPhones, Intel will ship more processors, and Microsoft will sell more software.
The moral of the story: Diversify and think long-term
Just like virtually any other factor that could potentially affect the stock market, rising interest rates are good for certain dividend stocks and bad for others.
Bear in mind that nobody knows exactly when rates will start to rise, how many increases there will be, and how long the higher rates will last. For that reason, it's unwise to try to time the market by buying nothing but stocks that will benefit from rising rates. In contrast, the best thing you can do is to develop a diverse portfolio of companies that will be winners over the long term. If you do this, some of your portfolio will benefit when rates rise, and others when rates fall once again. With this approach, over time you're almost certain to be a winner.