Investing

Jittery dividend investors should keep calm and carry on as interest rates rise

Donald Trump’s election has turned a slow trickle out of income stocks into a flood. Here’s why you should resist going with the flow

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Investor on bicycle looking at a fork in the road

(Illustration by Iker Ayestaran)

Investors are an obsessive bunch. They get preoccupied with all sorts of things—elections, central bank policies, the weather—but nothing has dominated investor thinking as much lately as bond rates and income stocks. Since the Great Recession, fund managers have been talking about rising fixed-income yields and their impact on equities and, more specifically, dividend-paying companies. Numerous experts have said that in a rising rate environment, investors should sell off their utilities, telecoms, real estate investment trusts (REITs) and other interest-rate-sensitive equities that they’ve been overweighting all this time.

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Up until now, this issue has mostly been watercooler fodder, but with the Federal Reserve having raised rates in December and Donald Trump’s election victory causing the 10-year treasury yield to spike by 19% since election day, many investors are now reducing their exposure to these rate-sensitive sectors. Others, though, think selling out of these companies, which are typically stable, reliable and long-lasting, is a fool’s errand. Longer-term, businesses in these sectors are still incredibly valuable investments, says Ryan Bushell, vice-president and portfolio manager with Leon Frazer & Associates.

Here’s the logic behind the Sell thesis: The most rate-sensitive industries are also the most leveraged, so the debt they’re holding will become more expensive to service. Also, as bond rates rise, some of the money that migrated over from the bond market in search of higher yields will return to the safety of fixed income. Income-generating sectors have seen their valuation multiples rise over the last few years too, such that many investors think they’re due for a fall.

While these reasons are valid, too many investors are obsessing over interest rates, says Jason Gibbs, a dividend-focused manager with 1832 Asset Management. It’s just one factor to consider, he says, and people should never base their investment decisions on one thing—nor on short-term market reactions. Plus, rates are still exceptionally low. Gibbs uses the example of BCE Inc. (TSX: BCE) as a reason to hang on. He expects the telecommunication company’s dividend to grow by about 3% a year going forward. With a current yield of 4.75%, that should give investors about an 8% total return, he says. Compare that with the 1.5% they’d get from holding a 10-year Government of Canada bond. Plus, in non-registered accounts, those dividends are taxed at a lower rate than bond interest.

Even if rates rise further—Canadian rates have jumped more than 50% since July 25, from 0.99% to 1.51%—the gap between stock and bond returns still yawns wide. Ten-year bond rates would have to climb to 6% to be equivalent to a 4% dividend yield after taxes, says Bushell. “I don’t even know if it will ever get that high,” he says.

Many of the sectors in question did well in 2016, in spite of the rise in bond rates. Canada’s utility sector is up 9.5% in the first 11 months of the year, REITs have risen 7.5% and several telecoms are up more than 8%. Our outsized energy index, which has helped push the S&P/TSX Composite Index up 15% year-to-date, also includes several rate-sensitive stocks—though they’re more susceptible to movements in oil prices—and is up 33%.

Energy infrastructure stocks, such as pipeline companies Enbridge Inc. (TSX: ENB) and TransCanada Corp. (TSX: TRP), should continue to see growth no matter the rate environment, says Bushell. While oil prices have been volatile, Canadian production keeps rising; volumes are much higher today than they were a decade ago. “There’s more work for these companies to do than ever before in history,” he says.

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Bushell is also bullish on telecoms and utilities in light of demographics. More immigrants are coming to Canada and parents are now buying phones for their kids, he says. He was surprised to see 370,000 new sign-ups in post-paid wireless subscribers in Canada last quarter, which is about double the rate of the past few years. Utilities will benefit through further infrastructure spending—companies can increase tolls to cover not only their expenses but higher borrowing costs, too.

REITs are the only interest-rate-sensitive sector that Bushell isn’t keen on. An increasing number of people are working from home, which will reduce demand for office space. There are still pockets of opportunity, but overall “there will be some pain felt.”

All dividend stocks risk a hit to earnings from interest rates in the short term, says Rich Peterson, a senior director at S&P Global Market Intelligence. He expects earnings for the S&P 500 to grow 12% in 2017, but earnings for REITs, utilities and telecoms to expand more slowly; U.S. utilities will see only 0.8% earnings growth, he says. If you take a longer outlook, though, he also thinks that these sectors still have room to grow.

Whether to sell or stay put comes down to how fast you think rates will rise. If American inflation climbs more than expected and interest rates spike, then these stocks will fall hard, says Peterson. They could also take a hit if uncertainty around the Trump administration’s impact on inflation and the Federal Reserve (of which he’s been critical) rises. However, most experts think we’ll see a gradual rise in rates. Many expect rates to stay historically low for years to come.

Likewise, the aging of the population dictates that demand for income investments will remain high. Most dividend companies are sturdy operations whose earnings will grow. “Just do your homework,” Gibbs advises. “Look at the fundamentals and don’t overreact.”

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