How Interest Rates Affect Dividend Paying Stocks

The aggressive rising pace of inflation in the market means that investors will need a new strategy to keep their portfolios afloat. Historically, the effect of high inflation over the long term is somewhat nebulous – stocks seem to be able to eventually absorb the impact of higher rates and adjust to the new economic environment relatively well. The short-term impact of inflation in the markets is where things become more complicated.

In general, rising rates means higher volatility for stocks and can often lead to lower values – at least, temporarily. This happens because higher interest rates means that companies must pay out more money for interest-driven expenses and leads to more expensive loans that need to be taken out in order to do business.

The extra expense translates to lower earnings, which means one of two things needs to happen: either stock values fall to adjust for the reduction in earnings or valuation multiples rise as investors essentially pay more for fewer future earnings. In the first case, investors will see the impact of higher rates relatively quickly. In the second case, higher multiples may help to prop up the stock’s price for a while, but may ultimately lead to higher volatility down the road. Investors can end up experiencing greater losses than anticipated if that last scenario plays out over a longer period of time.

The first reaction investors are likely to have in a possible market correction might be to buy defensive dividend-paying stocks, but those are the most vulnerable to under-perform first. Higher interest rates means that the dividend yield on a stock is under pressure. In order to maintain the same relative payout level, the company would need to boost dividends. The same problem happens with bonds – as rates go up, bond values drop.

Right now, the yield of a 10-year Treasury is 2.8% – otherwise known as the “risk-free rate.” That means that investors assume higher-than-average risk to buy stocks that come with a dividend yield of 2.8% or less. After all, why take on the risk of the stock falling when you can achieve the same yields in a safe-haven asset?

But dividend investors aren’t completely out of luck. There are still some places where owning a dividend-paying asset is worth the additional risk.

Certain market sectors thrive in a rising rate environment. The Financial sector, especially insurance companies and banks, tends to do well when interest rates are moving higher. For banks, higher rates translate to bigger gains on loans as consumers end up paying more in interest costs. Investors might think that higher rates would effectively be a wash for banks since it means higher interest rates paid out on savings accounts and CDs, but because long-term debt assets are impacted more strongly by rising rates than short-term ones, banks end up with a larger profit overall.

Insurance companies tend to perform well in this environment too. They are required by law to keep large amounts of money in highly liquid accounts and assets in order to meet their insurance claim payouts. Higher interest rates means higher yields on these types of investment accounts, boosting total earnings.

In all, the financial sector generally benefits the most from rising rates. Higher rates equal higher margins for banking and insurance stocks, which are able to invest at higher rates of return and charge more for their products since most are based off of the 10-year Treasury yield. And, therefore, banks earn more from the spread between long-term debt and short-term debt. Because most financial stocks come with relatively high dividend yields, this sector is the best one to find strong dividend investments with long-term profit potential.

The other sector investors will want to check out for dividend-paying stocks is consumer staples. Higher interest rates are often precursors to a boost in consumer saving when they can receive higher-than-usual interest in their savings accounts. But even with a drop in consumer spending, one thing that remains steady is the demand for staples such as groceries, healthcare needs, grooming products and other items that aren’t cut back, regardless of economic health. This means dividend-paying consumer staples stocks are a great, safe yield to pick up in volatile markets.

Many investors flee to traditional safe-haven assets like gold and silver, but there’s a major flaw to this thinking that could end up costing them in the long run. If inflation is higher than the risk-free rate, usually based on the yield of the 10-year Treasury, then gold becomes the most valuable asset because it preserves wealth. If not, investors are better off in an growth-oriented asset instead.

Right now with inflation outpacing interest rates, precious metals are a strong investment. Investors will want to keep an eye on interest rates and inflation rates before deciding to add any high-yield stocks into their portfolio.

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