As rates rise, dividend stocks could suffer

Canada’s overnight rate has climbed by five times since 2017; it hasn’t jumped this much since 2005 when rates rose by 2% over 21 months and that has many people worried about variable rate mortgages and other floating rate debts. While rising payments is something to be concerned about, especially since Canadians are mired in debt, the rate hike has been doubly difficult for dividend-seeking investors.

Over the last 15 months, some bond-proxy industries, sectors investors tend to gravitate to when bond payouts are low, as they have been since 2008, have seen prices plummet. The S&P/TSX Composite Index Utilities Industry sub-sector index is down 11.35%, according to S&P Capital IQ, while Canada’s telecom companies have fallen by 0.5%. In the U.S., those two sectors are up 5.95% and 0.26%, respectively, but they’re dramatically underperforming the S&P 500’s 14.5% gain.

If history is any indication, interest rate sensitive sectors, which include utilities, transportation, real estate and telecom, could struggle in the year ahead. In March, the Globe and Mail looked at the relationship between these sectors and yields on the 5-year Government of Canada bond. It found that when fixed income yields fall, these industry’s prices climb and vice versa. The inverse relationship was most pronounced in the utility sector, where, over the last 20 years, stock values nearly doubled, while the yield on the 5-year Government of Canada bond fell by about half. As fixed income yields rise, you’re starting to see prices in some of these sectors decline.

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Buy more bonds?

If five rate hikes in less than a year-and-half seems like a lot, then brace yourself: Most experts expect the Bank of Canada to hike rates three more times in 2019. The U.S. Federal Reserve, which has increased its Fed Funds rate eight times, to 2.25%, since December 2015, is also expected to raise rates further next year.

In theory, these sectors should see prices drop even more. Why? Because at a certain point bonds, with their now higher yields, start looking more attractive than stocks, which is the more volatile asset class. Rising bond yields also make it more difficult for some companies to service their debts, while the consumer impacts of climbing yields—rising mortgage rates, for instance—can cause consumer spending, and therefore earnings, to slow. Many people blame rising bond yields for the stock market’s late-January selloff.

Investors are now in a bit of a bind. Should they reduce their exposure to interest rate sensitive sectors, which also tend to be more defensive and, therefore, do well in a more volatile market environment? Or should they buy more bonds, which now have higher yields? The answer comes down to how much of a risk you’re willing to take.

Ben Homsey, a fixed income portfolio manager with Leith Wheeler Investments says that more conservative investors may want to buy into bonds with those now higher yields. “They can obtain higher portfolio yields with less volatility than equities,” he says. Patrick Reddy, a fund manager who runs Leith Wheeler’s dividend fund, still thinks equities will outperform, but he has been avoiding the utilities sector and other rate sensitive industries over the last few years. He’d rather own companies that can grow earnings and dividends year after year, even if a company’s payout is low.

CN Rail, for instance, has been able to grow its earnings by an average of 13% per year and its dividend by about 15% per year. While its yield sits at just 1.6%, it’s more important to him that it increases its payments annually. As well, with a 30% payout ratio, it should be able to maintain its dividend if it ever runs into trouble. “These are the kinds of businesses we’ve gravitated toward over the last several years,” he says. He does mention that he’s starting to look at utilities again, as they now look less expensive than they did a couple of years ago, but so far he hasn’t added any to his portfolio.

A harder choice

As yields rise, the choice between bonds and stocks may not be as clear to some investors as it has been over the last few years. While some interest rate sensitive sectors are becoming more attractive as valuations have fallen—the utility sector’s price-to-earning ratio was in the hight high double digits two years ago and is now trading at mid-double digits—but it’s likely prices will continue to be volatile.

From a total return basis, with 10-year bonds yields only nearing 3%, stocks should continue outperforming fixed income for some time, but if rates do continue to rise then there may be a point at which investors will rotate out of stocks and into bonds. It’s not clear when that will be, but there will come a time when it happens.

Investors should review their asset mix and see if there are less rate-sensitive dividend stocks to buy—and dividend companies can still provide a decent income to people who need a steady payment—but, ultimately, everyone should expect more ups and downs as all investors try to make sense of our new rising rate world. “I don’t know where rates are going to go,” says Reddy, “but I wouldn’t be surprised if it leads to more volatility.”