How will dividend stocks fare as rates go up?

Interest rates have started creeping up over the last few weeks … everyone from former FDIC head Sheila Bair to folks at the International Monetary Fund are now warning  that we could see serious financial problems dead ahead … and our own team now believes the Federal Reserve’s 25-year monetary experiment comes is about to come to shocking close.

So given all that, I want to start talking about how this situation might affect some of the investments and strategies I favor.

Let me start by saying that higher interest rates should be great news for conservative investors and savers. They will finally allow us to get fair returns on our money without requiring larger-than-normal risks.

At the same time, there is no doubt that lots of portfolios are going to get crushed along the way.

I believe bond investors have the most to fear, and I have been saying so for quite some time now. But I won’t pretend that dividend stocks are entirely immune. 

This is precisely why I have been preparing my Income Superstars subscribers for months now — especially when it comes to utility stocks.

Why I’ve Already Recommended Lightening Up on Utility Stocks …

Utilities are the stock market sector that gets hit the hardest by rising interest rates.

This is for two major reasons:

Reason #1: Rising rates crimp their corporate finances.

For the most part, regulated utility companies charge set rates — fixed by state and municipal governments. So that means their income is pretty much set in stone at the start of their rate period.

At the same time, their operations are very cost intensive and depend on lots of borrowed money. As rates increase, their ability to take on new debt for expansion and improvements decreases.

The end result is a strain on their cash flows and profitability.

Reason #2: Their dividend yields become less competitive

As interest rates go up — and we see higher yields on CDs, money markets, and bonds — investors have less need for dividend stocks.

This is obviously true across the board, but it’s especially true of utilities. After all, they aren’t known for big, fast capital appreciation. If anything, they’ve always been called “widow and orphan” stocks because they act more like bonds than equities.   

Of course, I am NOT saying you should abandon all your utility shares.

While I have previously told my Income Superstars subscribers to sell a few positions, I am still recommending select utilities like Con Ed and Exelon.

So What Separates the Safer Utilities from More Dangerous Ones?

To find out if your utility holding will hold up under the pressure of rising interest rates, make sure the company has a solid cash position compared to its current debt.

If a company needs to issue more debt or head to the stock market to raise capital for expansion and operations soon, it will be the first to suffer when rates go up.

A great little ratio you can find on most financial quoting websites — or your broker’s site — is the “quick ratio.”

Basically, this measures how much cash and short-term securities a company has in comparison to its near-term liabilities.

The actual formula is cash + short-term securities + receivables divided by current liabilities, like short-term debt.

This gives you a sense of how much near-term liquidity a company has at its disposal if rates were to suddenly rise.

The higher this number is, the better. So anything over a 0.8 or 80% (depending on how your preferred site lists it) should give the company enough room to work in the short term.

The second number you can look at to tell if a utility is positioned for a rate hike is its long-term debt to equity. I’m using long-term debt, since we already accounted for its short-term debt coming due with the quick ratio.

As the name suggests, long-term debt to equity gauges how much debt a company has compared to its equity, or book value.

Basically, it shows you how much financial leverage a company has used. A higher number means a company is more leveraged, which is a bad thing if rates are rising.

So you want to look for a LOWER long-term-debt-to-equity number. Anything under 0.8 or 80% is good.

Of course, since utilities are such a special type of business, it may be okay to make an exception for a company with a ratio as high as 1 or even 1.1 (100% or 110%) if it has other factors in its favor.

One last thing to remember is that quality dividend companies — including utilities — have the ability to continue increasing their dividend payments as time goes on.

So even if they get hit as rates jump, they have the potential to hand out ever-increasing streams of income over the long-term.

That’s one of the primary reasons I will ALWAYS recommend them for retirement portfolios, even as interest rates start rising more sharply.

Best wishes,

Nilus