Financial experts were telling two stories about how higher interest rates affected dividend stocks. Both stories have some advantages, but they say opposite things.
The first story is that dividend stocks are the place to be at times like today.
According to this story, steady dividend payers are in a position to hold up well in the current turmoil because they put an instant and steady stream of money in your pocket. In contrast, technology stocks and similar growth investments are likely to suffer because the potential to reap the rewards years from now becomes less exciting when interest rates rise and reduce the present value of future payments.
The second story is pretty much the opposite of the first. She says higher rates of damage inevitably go to dividend stocks. The logic here is that dividends become less convincing as the return on competing investments, such as bonds and savings accounts, grows. A stock that pays you a 4 percent dividend seems like a great deal when bond yields are close to zero. However, their appeal is waning, if higher-quality bonds start paying very similar rates.
Both stories seem plausible. But which one is actually correct?
The market cannot make up its mind.
Just as the first story predicted, tech stocks have been battered since interest rates started rising. The technology-focused Nasdaq is down more than 20 percent since the start of the year. Shopify Inc. lost. Canadian two-thirds of its value.
Meanwhile, some dividend stocks did just fine. Utilities and telecoms companies, in particular, have performed admirably during challenging times.
But the second story also proved true, at least in some corrections. Just as this story predicted, some of the more reliable dividend payers – banks and REITs – have taken their blocks as prices have soared. Canadian bank stocks have struggled since early February, while Canadian REIT indices have lost more than 10 percent since the start of the year.
This pattern in which some dividend stocks win during a period of high prices while others lose is puzzling. It is also unusual.
As CIBC’s Ian de Verteuil pointed out in a report this week, utilities and telecoms stocks usually lag behind the market when prices rise. Its current popularity is an anomaly.
He points out that this unusual pattern reflects broader economic tensions. In the past, higher interest rates have often gone hand in hand with growing optimism about the North American economy. The opposite is true now. Many people worry about the possibility of a slowdown in the future. Today’s rising interest rates are not the result of growing optimism. It is the result of the need to bring inflation to heel.
Given the cloudy economic outlook, it makes sense for investors to look for defensive stocks that can provide shelter against a potential storm. Utilities and telecom companies stand out in this regard. No matter how severe the economic weather is, people will continue to pay their electricity and phone bills.
In contrast, other dividend stocks are exposed to the full force of interest rate headwinds because they are more economically sensitive. Banks and REITs, in particular, are likely to feel the brunt of any economic slowdown (although in the case of banks this may be partially offset by higher net interest income). So perhaps it’s no surprise that their stock doesn’t boom as prices go up.
This explanation is very logical. However, it also raises questions about what will happen next.
Mr de Vertuel argues that as long as the 10-year government bond yield, now about 3 per cent, remains below 4 per cent, utilities and telecoms stocks should hold up well. He particularly likes Hydro One Ltd. and Atco Ltd. Between Utilities and Rogers Communications Inc. and Quebecor Inc. and Cogeco Inc. Among the telecommunications companies.
Beyond his report, investors may also want to consider the underlying logic of the situation. History indicates that dividend stocks for most items typically lag behind the market during periods of high interest rates. This corresponds more to the second story than the first.
If history is any guide, investors should not lose sight of the broader market. In particular, they may want to pay attention to defensive stocks that can continue to advance during economic downturns, but aren’t bought primarily for dividend yields.
Powerful carriers such as Canadian Pacific Railway Ltd. The Canadian National Railways is in this category. So does a retailer like Walmart Inc. , which fell as a result of the recent mistake but usually does well during downturns in the broader economy. No matter what story about high rates you buy, or the outlook you have for the economy, such stocks are likely to hold up well.
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