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4 Dividend Payers for a Higher-Rate World

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Even though the Fed said they're going to keep rates low for a considerable time, investors are preparing for a potential increase in rates. I'm here with Josh Peters--he's editor of Morningstar DividendInvestor newsletter and also our director of equity income strategy--to talk about what impact that could have on dividend-paying equities.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Now, I know you don't provide any kind of forecast on what's going to happen--

Peters: No, no, no, no, no, no, no ...

Glaser: But I do have to ask, generally, what's your take on how the Fed is handling the situation right now? Do you have a rough timeline of when we could see short-term rates start to tick up?

Peters: I really do not. I try to avoid like the plague making specific macro predictions, especially with a specific timeframe in mind. First of all, I have a terrible record. I bought my first house in April of 2007. I almost top-ticked the Chicago housing market. I proved to everybody's satisfaction that I can't time these things.

But on the other hand, I think what you need are planning assumptions, as opposed to a forecast. And one of the basic planning assumptions that you should have as an investor, especially with higher-yield equities, is that interest rates are going to go higher over the long term. There's just not that much room for them to drop. And the farther out you look, if you assume that the economy continues to heal and that eventually things get back to what we would think of as normal, then that probably correlates to a 10-year Treasury rate not in the 2s or even the 3s but maybe in the 4s. It's not a specific forecast, but the way I use it is to say, "Here is the basic direction we're going in and I don't want to pay a valuation for, say, an interest-rate sensitive stock that is inconsistent with a 4% to 5% long-term Treasury rate."

If I am, then once that happens--if it happens--then I'm going to suffer a valuation contraction and possibly a loss of capital. So, that's what I want to avoid.

Glaser: Dividend-paying stocks are often seen as very interest-rate sensitive. Do you see it that way? Do you expect to see a big crunch if we do get into that 4% to 5% range?

Peters: That's a time-horizon question. When we get to that day or week, you could see a big sell-off. You could see a big sell-off in this segment of the market or any segment of the market, really, for any reason. I don't think there is any point really trying to control for that.

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How you combat that is to have a long-term time horizon--pick companies you want to stick with through thick and thin. When you start thinking about rates eventually moving up and then normalizing--what does the market look like at the end of that process--then I think it is very much a matter of a stock-by-stock basis. REITs, for example, is one area of the market that I think is kind of expensive. You've got some names out there with 3% yields, even 2% yields. People who know REITs can remember 15 years ago when they routinely--even the high-quality ones--yielded 8%, 9%, 10%. That's not the kind of environment we're in today. I think there is a lot of rate risk. There is a lot of risk that those valuations suffer possibly considerably as rates just normalize.

On the other hand, with the most bond-like REITs, it's kind of a curious thing--and it's just my opinion--but Realty Income (O), for example, with a lease portfolio that has a 12- or 13-year duration, they are writing 15- and 20-year triple net leases. That stock is trading at over a 5% dividend yield. The spread of its dividend yield relative to the Treasury rate is actually wider than normal--and certainly wider than it was back the last time a 10-year Treasury was up in the 4% to 5% range.

So, I think that name is actually discounting that reversion to normal in interest rates in a way that some other property types are not. And then you can also fold in, say, the health-care REIT operators: Health Care REIT (HCN) is one of my favorites. I've also been looking at Ventas (VTR). These names have terrific secular tailwinds from an aging population. So, you get some income growth; that will help you offset some interest-rate pressure as well as paying the intelligent prices upfront.

Glaser: Other than REITs, are there other dividend payers that you think are priced right now for this more normalized rate environment?

Peters: Utilities are an area I'd actually say that has gotten kind of fluffy again, in terms of valuation. So, what you want to look for is something different, something that gives you some opportunity. Southern Company (SO) is a pretty good example. It's now my largest utility-industry holding. The last couple of years, they've had some construction projects that haven't gone well for them, and it's weighed on the valuation. Normally, this is a stock that trades at a pretty good premium to the peer group. Now, if anything, it's trading at a discount.

The yield is up close to 5% now, and the net effect of these project troubles they've had has really been pretty small because it's such a large company. As interest rates move up, yes, you're going to have some pressure, I think, on utility valuations. But Southern Company, in particular, with its story--with the opportunity to get past some of these hurdles--I think it has the opportunity to improve its valuation relative to the group, and that in turn will offset, perhaps, some future interest-rate pressure.

Those are the kinds of situations I think you want to look for, where you can use the individual stock picking--getting out there, the "shoe leather"--and looking for a good story that can work and has some margin of safety to it as opposed to just running away from higher-yielding equities, in general. There are much better ways of handling that and keeping that dividend exposure.

Glaser: So, don't worry too much about the timing of any increase--just know that it will probably get to a normalized rate at one point and really keep stock selection in mind.

Peters: A lot of it comes back to the serenity prayer. You focus on the things that you can control. And your allocation, how long you plan to have it in dividend equities, I think it should be essentially forever. And what you own for stocks--what industries, what individual names you're going to own--I think that's how you work with it. Because if interest rates really move up and get out of control, everything is going to get hurt.

But I'd rather own these stocks, even with their interest-rate risks, in exchange for the income that I get. (And anywhere you're going to get income, you're probably going to have some rate risk these days.) Then, there's the growth of income that you're only going to get from dividend-paying equities and the fact that they are more defensive; you're not taking the same economic-growth risk that you do in other areas of the market.

So for me, yes, there is rate risk, but I have to embrace it in exchange for these three big benefits that redound back to my portfolio over the long run.

Glaser: Josh, thanks so much for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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