Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Federal Reserve keeping interest rates at record lows, many are turning to dividend stocks for yield, but what will happen to those stocks as interest rates begin to rise again? To answer this question, I have Josh Peters. He is editor of Morningstar DividendInvestor.
Josh, thanks for joining me.
Josh Peters: Good to be here.
Glaser: So, let's take a look at your outlook for interest rates first. I think certainly nobody knows for sure when rates will start to look a little bit better or start to rise. When would you expect the Federal Reserve to act?
Peters: Well, I try never to have a very specific forecast. I think that's really a mistake for investors to say that they have a very clear outlook on exactly where rates are going to go and then trying to position themselves around a specific forecast. I like to think in terms more of hedges. So, interest rates could go up certainly from where they are now. They might also go lower. They could just stay here for a while. [Asking] how will my portfolio perform under some different circumstances and what kind of stocks do I own to meet those challenges, I think that's the right way to think about it, is in terms of risk control.
But at this point, I actually have a little bit stronger view on the long-term outlook for interest rates than I would normally have because I think the Fed really has the power to keep interest rates, at least on the Treasury curve, very low for an extended period of time, in part because of its own buying power, and in part because of people's liquidity preferences and [willingness] to hold bonds, even in a very low interest rate environment. The Fed's requirement that banks hold more liquidity, that winds up going into the Treasury market. I think that's something of a structural shift. So, I don't really doubt the Fed's ability to hold interest rates very low.
Now, at some point, you would expect inflation starts to pick up and then the Fed needs to respond. Well, what happens before that happens is a good way to think about it. I don't think we can really see a significant shift up in interest rates until the housing market has recovered in the context of a broader economic recovery, and housing specifically is now on a path where the prices can be stable or even rise a little bit even if interest rates start to creep up a little bit. Of course mortgage rates have a very large impact on the value of residential real estate. How long will that take? I mean even if the housing market is really starting to recover right now, it might be two or three years or more before monetary authorities are confident enough in that recovery to start taking some actions on interest rates. So, I think we could be in here for a period where 1.5% 10-year Treasury could start to look normal for a while.
Glaser: You've mentioned that investors need to think about hedges then, of how to prepare themselves for rising rates. What dividend-paying stocks do you think are going to perform better in that environment? Which ones do you think are going to do worse?
Peters: Well, I think you can just kind of separate the universe into two camps. On one hand, you've got the stocks that have been really the biggest beneficiaries of this environment; that's an AT&T, a Verizon, a Altria Group, a Southern Company. They are well-known names that have very stable earnings, very stable cash flows, an ability to fund a very generous dividend, and still provide for a dividend growth of 3%, 4%, or 5% a year on average over the long term.
If we move into a higher-interest-rate environment that correlates with a stronger economy, on the fundamental, on the earnings and dividends side, these companies really don't have anything to gain. It isn't like their growth rates are going to double or triple in a faster-growing economic environment because frankly they didn't get hurt that much by the economy that we’ve been dealing with here for the last couple of years. But they do have something to give up on the valuation side.
When you see these stocks trading at historically low yields, yes, Treasury rates are very low, but at some point, rates will go up. A more normal level for the 10-year Treasury is the rate of inflation, call that 2%, plus about 2.5 percentage points of additional return for a premium, that implies around 4%, 4.5%, or maybe 5% 10-year Treasury rates on a normalized level. Does AT&T look as attractive to investors, if a 10-year Treasury gets you 5%? I don't think so. I think that's a stock that could lose some of its valuation premium.
On the other hand, you have some stocks, not a whole lot of them, but some stocks that are out there that you look at a chart of their stock prices in this environment or their dividend yields in this environment, and you don't see this huge correlation. You don't see that the dividend yield is marching downward, meaning the stock price is marching upward, in lockstep with the fall in interest rates.
Over the last couple of weeks, I've been looking at and even buying some shares. My first foray into sort of that mixed merchants/regulated utility area was with Public Service Enterprise Group. Here's a stock that's been yielding right around 4% or 4.5% over the last couple years. Even as rates have fallen, its stock price hasn't gone up because it's perceived as being more sensitive to the economy, specifically sensitive to regional power prices. If the economy picks up, natural gas prices pick up, and energy prices pick up, PSEG is going to make more money. The firm is going to be in a position to raise its dividend faster, and you don't have the same downside risk associated with a yield that has become too low because of the low interest rate environment. I like a story like that.
I like some of the banks where their earnings are being hurt by very low interest rates at this point in the cycle. As the interest rates start to go up, their profits will go up; their ability to pay dividends and raise them will go up. Those are stocks that I don't think are being inflated by a low-interest-rate environment. If anything, they are being hurt by it. So if I move in there, I can pick up some decent yields, and in some cases, very good yields, without having to again take the risk associated with an AT&T or an Altria or a Southern Company, where they have nothing to gain from a better economy, but they have something to lose in terms of their valuations once interest rates go up.
Glaser: You manage the model portfolio for the DividendInvestor newsletter. Can you talk a little bit about changes that you've made there, particularly thinking about the potential of rising rates in the future?
Peters: Well, I haven't made many substantial changes to our Dividend Builder portfolio, which targets 3% to 4% yields and faster dividend growth to compensate. My recent activity is really been more over on the Harvest side, that being an account that targets 5% to 7% yields. I own stocks, have for some time, like AT&T and Altria that provide these traditionally high dividend yields, but don't grow very fast.
So, lately, it's been a process of realizing that some of those gains that we've earned here really this year or maybe even late last year represent something of a windfall. I could just do nothing. I don't expect them to cut their dividends; their dividend growth rates haven't changed. I could just sit back and let the market take care of itself even if that means my portfolio is worth less on paper going forward at some point in the future. On the other hand, I could try to look for opportunities to capitalize on that windfall by moving money into names like a Public Service Enterprise Group that has some upside associated with the economy, and its stock doesn't have as much sensitivity to interest rates.
So those are the kind of moves that I have been making gently. I'm not selling out of long-standing positions like an Altria or a Realty Income. Those are very difficult companies to find trading at bargain valuations even on the best of times for buyers when prices are low. So I tend to want to hold on to big stakes there, but taking some money off of the table and moving that money into stocks that have a little bit more cyclical exposure, I think that's a good trade-off, when you start having that three- to five-year view that interest rates will stay low for a while, maybe longer than people want. But at some point, they're going to go up; at some point the economy is going to be better. And I want to have some opportunity to participate in that while getting the dividend income, while getting the high yields and the consistent dividend growth that I would expect from any stock.
Glaser: Josh, thanks for your thoughts today.
Peters: Thank you, Jeremy.
Glaser: For Morningstar, I am Jeremy Glaser.