As pointed out yesterday in this Market Musings piece, the negative reaction of traders to the possibility of gradual, incremental increases in U.S. interest rates has more to do with the short term outlook that their job demands than any fundamental issue. Talk of a rate hike is only possible because the data suggests that economic recovery, while still bumpy in places, is continuing. That makes any pullback a buying opportunity for investors, but that doesn’t mean that care isn’t needed when selecting what to buy.
In order to make that choice the most important thing to understand is what not to buy. Conventional wisdom says that in a rising interest rate environment, dividend paying stocks, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) should be avoided. There has been no shortage of people repeating that advice this time around, but, as is too often the case, most have failed to explain why.
As somebody who spent nearly twenty years as a market insider I can assure you that arrogance and assumptions, rather than the evil that some presume, are far more likely explanations for the omission.
Those who trade and watch markets every day frequently say thing like. “...of course this will be bad for REITs, but...” It is so obvious to them that they assume it is to everybody, which of course isn’t true.
As indignant as this trait sometimes makes me, I would happily ignore it if it made no difference to investment decisions that you, the retailer investor may face. The fact is that it does make a difference. Strategy over time for dividend stocks, REITs and MLPs will vary, and understanding why they react to interest rates as they do is the key to making decisions later.
The reason such securities are sensitive to interest rates is because, like bonds, they derive much of their value from being a source of income for investors. Most people don’t buy a REIT, for example, looking for capital appreciation. They do so to get payments, probably quarterly, that amount to maybe as much as 6-7% of capital each year. The same can be said of MLPs and dividend stocks. Because of the similarity of use, these securities are often collectively referred to as “bond proxies.”
It follows logically that if securities are being used as alternatives, their price will be linked to the price of bonds, so it is the effect of a rate hike on bonds that makes bond proxies something to be wary of in a rising rate environment. If the Fed sets generally higher rates, then the bond market, led by Treasuries, will respond. Market interest rates will rise along with pre-set rates, and in order for that to happen the price of bonds must fall.
The bonds pay a fixed percentage of their face value, so if the rate (the coupon) cannot be adjusted, the price must change to alter the effective interest paid. For example, a bond issued with a face value of $100 and a coupon of 5% pays $5 of interest every year. That payment amount doesn’t change in dollar terms. If prevailing rates jump to 10% then the price of that bond will be adjusted until it matches that return of $5. In this case the price would fall to $50, where the $5 payments represent a market matching 10% yield.
This is an extreme example and takes no account of the time for which that interest will be paid (the maturity date, or end date of the bond), which also affect the price, but it illustrates the basic relationship. If bonds must fall in price it follows that other sources of income will too, even if the dollar amounts of their payments aren’t fixed as they are with bonds.
That combines with the fact that the current yield on any bond proxy looks less inviting when yields rise on what the market considers “risk free” assets: U.S. Treasuries. Risking market volatility to return 5% when the 30 year government bond is paying 3.5% makes sense, but not when that same paper is paying 4.5%.
Any rise in interest rates will therefore put downward pressure on the price of anything that provides investors with an income, but rising rates will not have an equal effect on those stocks, especially over time. Higher interest rates generally come when at least some degree of inflationary pressure exists. In that scenario, most companies will see rising prices, and therefore income in dollar terms. That would allow them to increase the amount of any distributions, correcting the price drop. That is why, while buying any bond proxy now makes little sense, buying on any drop resulting from an actual announcement would be a decent strategy.
If you understand the relationship between interest rates and the price of income producing stocks then you can make informed decisions about when to sell your holdings, if at all, and when to buy once any news is priced in. Hopefully, if you have made it to this point in the article, you now have a better understanding of that relationship and can look forward to a rate hike as an opportunity, not a worry.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.