What to Expect as Interest Rates Rise

A version of the following article first appeared in the August 2013 issue of Morningstar DividendInvestor. Download a complimentary copy of DividendInvestor here.

We all knew interest rates would eventually go up, but that doesn't mean the move this year has been pleasant. Since May 1, when the yield on 10-year Treasury bonds hit its low for the year (1.61%), long-term rates have risen by more than a full percentage point. This riled the bond market, where investors have suffered losses from their bond holdings. The impact on the stock market--in general--has been less troublesome: Volatility increased for a while, but the S&P 500 has gone on to reach all-time highs.

Still, the universe of high-quality, high-payout stocks often reacts more strongly to trends in the bond market than the S&P. If you consume a fair amount of financial media, you've probably heard--repeatedly and vigorously--that the "dividend trade" is over. For hedge funds and speculators, that may indeed be true. History suggests that rises in the yield of 10-year Treasury bonds are indeed correlated with market-lagging returns on high-dividend stocks, though not necessarily losses in absolute terms. I don't find this fact all that interesting, let alone worthy of action, but it's always worth being prepared for a bumpier road.

But is the threat of higher interest rates sufficient to warrant a change in the basic strategy of DividendInvestor, or perhaps a wholesale departure for greener pastures? I don't think so. Every approach entails some risk; given the other merits of our strategy--including an insistence on economic moats and rewarding dividend growth--interest-rate risk is one I’m willing to take.

What Does History Say?
To get a sense of what we might expect in a cycle of rising long-term interest rates, I sliced and diced a bunch of historical data. I defined a rising-rate cycle as any move of 1 percentage point or more from a recent low, using monthly average values for the 10-year Treasury yield. Prior to the current cycle, there have been seven such periods since 1992. On average, these moves lasted 9.3 months and saw the yield on 10-year Treasury bonds increase by 1.55 percentage points.

It appears that the market in general has little to fear from these moves, as the average total return of the S&P 500 during these rising-rate environments has been 11.0%. For reference, the annualized total return of the S&P 500 since year-end 1991 comes in at 8.9%. Furthermore, the S&P recorded a positive total return in all seven periods of rising rates.

For high-yielding stocks, the verdict of history is somewhat less appealing--at least for investors who expect, or need, to outperform the market during short time horizons. The Dow Jones U.S. Select Dividend Index (hereinafter referred to as DJDVY) has trounced the S&P 500 since the end of 1991 with a compound annual total return of 12%. Better yet, its monthly beta has been only 0.78--that is, its monthly returns have experienced 78% of the volatility of the S&P. That said, in the rising-rate cycles described above, DJDVY has trailed the S&P with total returns averaging 3.7%. In three of the seven periods, DJDVY lost value, even with its ample dividends included.

However, these averages are skewed by two truly bizarre periods. The defining feature of the 1998-2000 stretch was not the rise in long-term interest rates, but rather the apex of the 1990s tech bubble. With the market seized by a speculative frenzy, otherwise sound common stocks were dumped for no sin greater than lacking ".com" in their names. Subsequent performance bears this out: In the two years following the March 2000 peak in the S&P, DJDVY earned a 61.5% positive total return while the S&P lost 21.5%. The other aberrant period runs from December 2008 through June 2009, when investors were gripped by panic: The yield on 10-year Treasury bonds plunged more than a full percentage point in December 2008, followed by a rapid bounceback. Excluding these two periods in hopes of identifying more natural relations between interest rates and stocks, DJDVY tends to lag the S&P only slightly.

Of course, no two interest-rate cycles are alike, and it may be misleading to read too much into data like this. However, the moves most analogous to our current one are probably 1993-94 and 2003-04. In both cases, short-term rates had previously been pegged at unusually low levels following financial stresses, the pace of economic recovery was disappointingly slow, and long-term rates started to rise before the Federal Reserve actually tightened policy. DJDVY underperformed modestly in the first period and actually beat the S&P 500 in the second.

Interest Rates and Intrinsic Value
All else being equal, there's no getting around the fact that higher interest rates reduce the value of financial assets. Imagine for a moment a stock that pays annual dividends of $1 a share with zero growth potential, and in order to own this stock, investors demand a 6% premium to the return on long-term Treasury bonds. If the 10-year Treasury yields 2%, investors require this stock to return 8%, so it's worth $12.50 a share ($1 divided by 0.08). If the 10-year yield rises to 4%, the required return jumps to 10%, making the stock worth $10--a decline of 20%. 

However, all else is almost never equal. Let's recast the example as a stock with a $0.50 dividend rate and a 4% growth rate for earnings and dividends. Given a 10-year Treasury yield of 2% and a 6% equity risk premium, this stock is worth $12.50 a share ($0.50 divided by 0.04, which in turn reflects the 8% investor return requirement minus the 4% growth rate). If the 10-year Treasury yield jumps 2 percentage points, but the company's growth rate increases by 2 percentage points as well, the two increases cancel each other out to leave the stock's intrinsic value unchanged. 

This explains why utilities are generally the worst performers relative to the market when long-term interest rates rise. Periods of low interest rates are usually associated with a weak economy--during or just after a recession. Utilities (at least fully regulated ones) tend not to suffer much by way of profit declines because the services they provide are nondiscretionary. When economic growth starts to improve, corporate profits rebound and interest rates trend higher--but regulated utilities are less likely to enjoy faster profit growth than other more cyclical sectors of the market. Similarly sticky dynamics are at work in consumer staples, telecoms, and real estate investment trusts. 

However, these sectors generally have the least to lose when the economy falls into its next recession. I'm happy to swap short-term underperformance during bull markets for better downside protection.

The Key Question: What's Priced In?
One of the more curious features of our current rate cycle is the reason interest rates have gone up. Usually, rates rise because of a combination of faster economic growth and upward pressure on inflation. But on the way to a full-percentage-point increase in the 10-year Treasury yield, the economy hasn't actually gotten much stronger, and inflation remains below the Federal Reserve's target rate of 2%. Instead, rates are up because the bond market fears an end to the Federal Reserve's most aggressive stimulus measures whether the outlook for inflation changes or not.

I don't have any specific outlook for interest rates, but I think it's safe to say that interest rates will eventually rise further. A 10-year Treasury yield of 4% seems like a reasonable planning assumption if the economy picks up a bit more speed and inflation stays low. But how and why we get there is more important than when. If interest rates rise because of a jump in inflation, that probably won't be good for stocks of any kind--but that's why I require dividend growth to maintain the purchasing power of our income. If rates rise because the economy is growing faster, that too should correlate with faster dividend growth from our stocks, even if more cyclical areas benefit more than we do. And if rates rise too fast or too far, the key threat might be a recession, in which case our defensive stance is ideal. 

Under any scenario, strong corporate balance sheets and economic moats are our best defenses. Moats are particularly valuable: By fending off the impact of competition, they help protect the profits that fund our dividends through downturns while encouraging dividend growth in better times. I wouldn't go through any interest rate or economic cycle without them.

The best news for income-oriented investors is that relatively few stocks--unlike virtually all bonds--were priced for 10-year Treasury yields staying at 2% forever. Morningstar's fair value estimates have never been predicated on the idea of a 2% 10-year Treasury yield. Instead, the equity return requirements embedded in the valuations of our portfolio holdings are either 8% (for the most stable businesses) or 10% (more-or-less average predictability). If rates continue to rise, I won't be surprised if these generally defensive stocks lag the market, but that's not my conception of risk. Due to our resilience in weaker periods, our portfolios have performed much better the S&P 500 over time without making any explicit attempts to forecast economic indicators or shifts in market sentiment.

In the final analysis, the beauty of high-quality, high-yielding stocks is that they offer "unfixed" income--attractive dividend growth potential--which long-term Treasuries do not. As long as our dividends are safe and continue to grow, I expect rewarding long-run results from our strategy, even if interest rates have further to rise.

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