Why Investors Need To Get Comfortable With Low Interest Rates & Dividend Stocks by Dirk S. Leach
The term “lower for longer” has been coined by the financial media to describe the most recent period of low interest rates over the last 6 years.
It was unthinkable 6 years ago that today, that 6 years later, the 10 year Treasury Bond rate would be sitting at about 1.5%. Because the income from bonds and other interest bearing investments is paltry, investors are turning more and more towards investments in dividend paying stocks and master limited partnerships (MLPs).
I had previously been squarely in the camp that believes we would see interest rates increase toward a more typical (or normalized) level driven by GDP growth, employment growth, wage growth, and healthy inflation. Over the last year I have read through dozens of articles including a number on economic history, taught a class in economics and investing, and given this subject a lot of thought.
As a result, my thinking has evolved to an alternate possibility. The US and much of the developed world may very well see interest rates low for very much longer, possibly decades.
Interest Income vs Dividend Income Today
Interest rates today are pretty low. The US 10 year Treasury Bond yields 1.5% and 30 year conventional mortgages can be found as low as 3.2%.
Companies with investment grade credit ratings can get loans or issue bonds at very favorable rates providing cheap capital for growth. This is all great news if you are in the market for a loan. But if you are in the market for debt based investments (bonds, bank deposits, mortgage securities), you will likely have to lower your expectations for returns. The chart and table below provide a summary example of the returns you can expect today from investments in US bonds/notes and bank deposits.
This is about as good as it gets for a “safe” return. All of the banks listed in the chart above are “online” institutions. Most brick and mortar bank’s money market funds are paying 0.1 to 0.2% interest and it is hard to get excited about purchasing a 10 year Treasury at 1.5%.
Many investors have turned to alternate investments than can provide a better return in exchange for higher market and/or credit risk. A number of new bond funds (ETFs and CEFs) have cropped up that use 2x or 3x leverage to boost income returns. While these leveraged funds have become quite popular with income investors, one needs to understand that leverage can be used to juice returns in a bull market but it also exacerbates losses in a bear market.
Dividend paying stocks are another option for investors seeking current income. I’ve written about a number of dividend paying stocks – including the Top Canadian Banks and The Best Monthly Dividend stocks – on Sure Dividend.
Sure Dividend’s stock recommendations have all been carefully researched and screened for income and total return potential but, like any equity investment, there is both market and credit risk associated with their ownership. For that additional risk of equity ownership, investors are being compensated with yields of up to 7.5%. It is no wonder income seeking investors have turned towards dividend paying stocks to generate current income.
The History of Interest Rates
I think the first thing that investors should understand is that today’s low interest rates are not all that unique in light of the historical trend of interest rates. Below are two charts with the first showing the 10 year Treasury rate back to 1912 and the second chart showing the rate back to 1790.
Source: US Dept of the Treasury
What do these charts really tell us? It looks to me that history is telling us a couple of things.
A 10 year bond rate over 5% is relatively rare. The only times bond rates spiked above 5% was after the Revolutionary War, during the Mexican American War, during the Civil War, during World War I, and then a long period between about 1970 to 2000. That last 30 year period appears to be the anomaly in the history of 10 year Treasury bond rates as it is the only time we’ve had 10 year bond rates above 5% outside of being in a war or recovering from one.
The other point to note is that the 10 year bond bounced around a yield of 2% between 1940 and 1950. While our current 1.5% is low by historical norms, it is not that much lower than we had between 1940 and 1950.
While the Federal Open Market Committee (FOMC) has been making noises about raising (normalizing) interest rates for about the last 4 years, the only bump they have provided was last December 2015 and it was a minor increase of 0.25%. The stated and unstated reasons that the FOMC has not raised rates further are many.
- The FOMC is data driven and the data has not shown sustained growth in inflation and employment.
- While the unemployment rate is down to 4.9%, the labor participation rate is also down to 62.8%, a level not seen since 1978.
- Wage growth is anemic.
- Other global economies are slow and/or slowing.
- Brexit may destabilize the global economy.
- It is an election year and the party in the White house doesn’t want to risk a recession.
I suspect that there is another reason that makes raising interest rates more difficult with the passing of every month.
Debt Service On The National Debt
Before I get too far into the subject of future interest rates, I want to make clear that I don’t believe it is possible to accurately predict the future direction or level of interest rates going forward.
However, I do believe it is important to understand the range of possible interest rates going forward to be able to make educated investment decisions. One growing possibility is that the debt service on the publicly held Treasury bond/bills would quickly become unaffordable if interest rates were significantly higher. Let’s look at this possibility in a little more detail.
The last time the FOMC made a significant move to raise short term rates was June 2004 with the national debt sitting at $7.3 trillion. Since then, the national debt has risen to $19.4 trillion, more than 2.6x in the 12 years since June 2004. And the growth in the national debt is not slowing down, it is accelerating.
Today’s national debt is mind boggling. We are just now seeing the massive wave of baby boomers begin to retire. That retiring wave of humanity will be drawing down on the Social Security (SS) “trust fund” and tapping Medicare.
Since the Federal government actually spent the money in the “trust fund” and replaced it with IOUs, both SS and Medicare are future unfunded liabilities that will increase annual budget deficits and the total national debt. The interest on that debt, while not quite as mind boggling, is none-the-less impressive. The table below shows the annual interest paid on