The US Federal Reserve (Fed) has since raised the Federal Funds rate (Fed rate) twice over the past two years – a total of 50 basis points – after almost seven years of near-zero interest rates. With interest rates maintained so low for such a long time, bond yields were low as well (negative in some places). Meanwhile, dividend stocks gained so much prominence, especially among income investors. But now that the Fed has raised rates twice, and will probably raise three more times this year, will our dividend stocks get hit and fall out of favour?
The general idea is that as the Fed rates are raised, debt becomes more expensive to finance. When the Fed raises the Fed rate target range, banks will increase the interest rates they pay their savers (albeit not immediately). Likewise, borrowers will be charged a higher interest rate as well. And most companies borrow money – not just from banks but also financial institutions. Which means their profit margin will be reduced because they will need to pay more interest on their debts.
In short, a higher Fed rate and ultimately higher interest rates would impact companies’ bottom lines. When that happens, stock prices would naturally face resistance and investors who can’t take on the risk or volatility will turn to safer securities like fixed deposits and bonds. But what about dividend stocks? Would their dividend yield be less attractive now that interest rates are higher? Because bonds and fixed deposits are technically a lot safer than stocks, almost at any given point of time.
Furthermore, dividends are typically paid out by companies’ net profits as a form of distribution of earnings and reward to their shareholders. When debt gets more expensive, as mentioned earlier, companies’ net profits will take a hit and ultimately affecting dividend payouts. Nevertheless, whether particular dividend stocks are still attractive or not depends on a number of factors, and here are a few for starters – (1) total debt, (2) sector (nature of the company) and (3) dividend yield.
Yes, debt will become more expensive. But not every single publicly-listed company holds large amounts of debt. These are the companies that would not be heavily impacted by rising interest rates (in terms of financing outstanding debts). In fact, rising interest rates usually mean that the general economy is doing well (at least that’s what the Fed thinks) and most companies would benefit. Tech companies don’t usually take up a lot of debt but that has been changing recently.
Even then, big players like Apple, Microsoft and Google are very cash-rich, which means they could easily service their debts if interest rates were to rise to levels against to their favour.
On another note, companies with little to no debt and pay dividends to shareholders typically performed better than their peers, as can be seen in the graph above. In fact, “Dividend Growers”, the companies that gradually increased dividends given out to shareholders, are the best performers. But that doesn’t mean every dividend-paying company will perform well, which brings us to the next factor – the nature of the company’s business.
Sector (nature of the business)
We should not forget that while debts are bad for companies, they are not bad for all companies. Banks are companies at the receiving end of the debt payments, which means they stand a lot to gain from rising interest rates.
Insurance companies will benefit too because the premiums we pay them would usually go into fixed-income securities. These investments typically thrive when interest rates are raised, too. While an increase in net profits would not necessarily mean an immediate increase in dividend payouts, we know for sure that they (banks and insurance companies, for example) will perform better.
Last but not least, the attractiveness of dividend stocks depends largely on the dividend yield (dividends relative to the entry price). This might seem very self-explanatory but there’s more. Renowned investment veteran and regular columnist of Shares Investment, Dr Chan Yan Chong, has always been a huge advocate for dividend stocks. He opined that dividend stocks are meant for investors who are willing to hold for a very long time – 10 years, 20 years or even longer. But to Dr Chan, if the dividend yield is less than four percent, it might not be that worth to buy.
This is considering a slight increase in interest rates might boost the returns of fixed deposits and bonds. In that situation, a low dividend yield (just a little higher than fixed deposit or bonds) wouldn’t justify the risk investors have to take versus the “risk-free” securities. As such, dividend yield percentage is another huge factor to consider when assessing if a dividend stock is worth it. Dividend stocks that have faced corrections are typically better because the dividend yield rises when the underlying stock’s price drops.
Also, in Dr Chan’s recent book (written and published in traditional Chinese), he mentioned that buying the dividend stocks of utility and transportation stocks are good ways to “deal” with rising prices of such daily consumptions. Buying dividend stocks, holding them for a long time and slowly reaping the dividends, is a great addition to any conservative or defensive portfolios. This is especially important in the current state of uncertainty.
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