As interest rates collapsed in the past few years to
multi-decade lows, investors had no choice but to flee
low-yieldinggovernment bonds and bankCDs for higher-yielding,
dividend-payingstocks . From masterlimited partnerships (MLPs)
andreal estate investment trusts (REITs) to foreign government
bonds, it's been an era of profitableinvesting .
Yet signs are emerging that this trend may start to reverse
Theyield on the 10-yearTreasury note has spiked higher since the
beginning of May to roughly 2.2%, and if we continue to see
robust monthly employment reports, then these rateswill probably
climb steadily higher as theyear progresses.
Simplyput , theeconomy is getting healthier. Even given the
likelihood that the Federal Reserve will keep itsbenchmark
interest rates quite low for a few more years, the
longer-termbonds , which are influenced by economic trends, have
begun to anticipate a broader upturn.
So are the MLPs, REITs and otherdividend payers likely to suffer
if investors start to see attractive yields in the safety of
government bonds and bank CDs? Not necessarily. But you need a
keen understanding of thefactors behind the rate changes, as they
will bring disparate effects to different types ofasset classes.
Before digging deeper, understand that the yield on the 10-year
Treasury is likely to rise at a slow pace, and it could be a year
or more before that figure moves past the 3% mark. The only
concern is thatthe Fed 's massive pump priming (known as
quantitative easing orQE ) is so unprecedented that we don't know
howbond prices will react when the Fed starts to wind down the
program. It could lead to a bit of chaos, which the bondmarket
hates. Still, as long as the 10-year Treasury remains below 3%,
it's premature to get too alarmed about the recent rate rise.
The Cost OfMoney
Putting aside for a moment the question of relative yields
between bonds and stocks, you should be more concerned about
which companies will be hurt or helped by rising rates. We've
already seen potential losers in the group ofmortgage REITs such
Two Harbors Investment (
AnnalyCapital (Nasdaq: NLY)
, both of which have fallen more than 10% in the past three
months. These firms take advantage of low borrowing rates and
garner profitable spreads by reinvesting theirfunds into
higher-yielding mortgage-backed securities.
Traditional REITs, many of which deploydebt leverage to boost
returns (or at least on properties that carry variable interest
rate debt), are also falling out of favor right now. In just the
past four weeks, a number of REITs have fallen more than 10%,
Cousins Properties (
Duke Realty (
National Retail Properties (
(Besides traditional yield plays, homebuilders will also feel
the pain of rising rates as pricier mortgages narrow the pool of
potential homebuyers.Shares of
D.R. Horton (
, for example, have slid 10% in the past month.)
Higher rates will be felt most heavily by companies that carry
variable rate debt, though you need to research and find out
whether a specific company's floating rate debt is tied to
, which is likely to stay low for a while longer, or
high-interestcredit lines that are more closely aligned with
10-year bond rates. Rising variable interest rates will start to
lead to lowerearnings for highly leveraged companies.
Conversely, any companies that have suffered from low returns on
theircash are bound to benefit.
Charles Schwab (SCHW)
for example, has made few profits on its money market funds or on
the cash balances it holds for clients. Rising rates would help
boost Schwab's coreearnings power .
In a similar vein, insurance companies will also soon start
earning more money on their hefty cash balances. I looked at this
group a few weeks ago and noted that what had been a big
headwind, pushing their shares belowbook value , could soon
become a tailwind.
Risks to Consider:
The yield on the 10-year Treasury has spiked higher in a
short time on several occasions in the past, so you may want to
see yields pushing above 2.5% -- a level not seen in nearly two
years -- before making major portfolio moves. Still, this is a
good time to think about the steps you'll take in such a
Action to Take -->
The longbull market in bonds that began in the early 1980s
appears to be winding down. Although dividend-paying stocks of
all stripes have benefited, it's time to separate the field into
winners and losers by looking at how interest rates affect each
of theseinvestments ' earnings. Any firm that uses very low
interest rates to juice profits has probably seen a peak in
profits, and smaller dividends may be looming ahead.
Add in the fact that risingfixed-income rates lessen the appeal
of riskier stocks, and a tide may be turning. Still, it will be
quite some time before fixedincome investmentsoffer the 4% or 5%
yields that many crave.