Will Rising Interest Rates Break Dividend Stocks? by Sure Dividend
The Federal Reserve has held short-term interest rates near 0% since December of 2008 to help stimulate the economy. The Federal Reserve decided to push short-term rates near zero during the depths of the Great Recession. That was over 6 years ago.
Since December 2008, the S&P 500 has risen 137%. Low interest rates have very clearly played a part in increasing real asset prices.
Not If, but When the Fed will Raise Rates
Many expected The Federal Reserve to raise interest rates in June. A recently-released account of an April Federal Reserve meeting shows that the chairwoman Janet Yellen and other Federal Reserve members are still concerned about the lower-than-expected pace of growth. As a result, they have not yet increased interest rates.
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This does not mean interest rates won’t rise in the next several months. The Federal Reserve indicated that they plan to raise interest rates – as soon as they feel comfortable with economic growth in the United States. An interest rate hike could already be in the works.
This language is in stark contrast to the Federal Reserve’s pledge to keep interest rates low for several years to stimulate the economy. The change in language means that interest rate increases are in the works soon.
Will Rising Rates Hurt Dividend Stocks? In Theory…
In theory, rising interest rates should impact slower growing assets whose return comes primarily from interest or dividends more than faster growing assets.
Rising interest rates damage bonds the most; 100% of a bonds return comes from interest payments and the return of principal at the end of the bond’s life.
On the opposite end of the spectrum is growth stocks with no dividend payments. These stocks pay nothing. Their value is entirely tied to their growth. In theory, these stocks should be least affected by rising interest rates.
Dividend stocks fall somewhere in the middle between a bond and a non-dividend growth stock. Not all dividend stocks are the same, however. They fall into two broad categories.
A dividend stock that shows virtually no growth (think utilities) and returns close to 100% of its cash flows to shareholders is more like a bond than a growth stock.
Dividend growth stocks (think Coca-Cola) combine the growth of stocks with dividend payments. They are more similar to a growth stock than a bond and should perform better than bonds and slow-to-no-growth dividend stocks during periods of rising interest rates.
Will Rising Rates Hurt Dividend Stocks? In Practice…
In practice, the historical data tells a different story. Both the S&P 500 and the Vanguard Dividend Appreciation ETF (a good proxy for dividend growth stocks) showed positive correlation with rising interest rates. Interest rates were measured using 10 year U.S. treasury yield changes from month-to-month since mid-2006.
The S&P 500 showed a correlation of 0.24 while the Vanguard Dividend Appreciation ETF showed a correlation of 0.19 with changes in interest rates. Interest rate changes are not a dominant factor in either the S&P 500 or in dividend growth stock returns. Counter intuitively, stocks have responded positively to rising interest rates in recent history. This is likely due to other factors and not because rising interest rates are actually positive for stocks in general.
Utilities as measured by the Spider Utility ETF showed a negative correlation with rising interest rates. When interest rates rise, utility stocks suffer. The correlation was just -0.1, so the effect was rather weak. It is likely that the negative correlation would more pronounced. if we were not in a strong bull market over much of the duration of the study.
Will Rising Rates Hurt Dividend Stocks? Possibly, But Not Significantly
Rising interest rates could dampen both normal stock returns and dividend growth stock returns. The effect is likely to be minimal and not a primary driver of returns one way or the other.
Rising interest rates will likely have significantly negative effects on utility stocks and other stocks that have very slow growth and pay out the vast majority of their earnings has dividends. These types of stocks behave more like bonds than growth stocks or dividend growth stocks. As a result, they are likely to be more seriously impacted by rising interest rates.
Stocks That Will Benefit from Rising Interest Rates
Not all stocks will be effected equally by rising interest rates. Some businesses stand to benefit from rising interest rates. Businesses that generate a significant portion of earnings from short-term investments will benefit from rising interest rates.
Banks could see gains from rising interest rates. If the spread between short-term and long-term rates increases, banks will be more profitable. Banks tend to pay out short-term interest rates on deposits and invest in long duration securities. An increase in the spread between short-term and long-term rates therefore benefits banks.
In addition to banks, payroll processors stand to gain from rising interest rates. Payroll processors hold large sums of money from businesses before paying it out to their employees. This cash ‘float’ is invested primarily in short-term securities. When interest rates rise, payroll processors will likely see their income rise as well.
The largest payroll processor is Automatic Data Processing (ADP). ADP is a Dividend Aristocrat in addition to being its industries’ leader. Unfortunately, ADP appears overvalued at this time. The company is trading for a forward price-to-earnings ratio of 26.2, and a current price-to-earnings ratio just below 30. Despite potential gains from rising interest rates, ADP is not a timely investment.
Insurance Stocks Will Benefit the Most from Rising Interest Rates
Insurance stocks will very likely see increased earnings from rising interest rates. When insurers collect premiums they do not simply put the premiums into a bank account. Instead, they invest premium revenue. When it comes time to pay insurance claims, the company sells a portion of its investments and pays the claim. The money that insurers collect in premiums before they must pay it out in claims is called float.
There are currently 3 insurance stocks that are Dividend Aristocrats. These 3 insurers have all paid increasing dividends for 25 or more consecutive years. A long streak of continuous dividends shows that these 3 insurers have not taken excessive risks. At the same time, all 3 are focused on returning cash to shareholders in the form of dividends. Each of the 3 insurance Dividend Aristocrat businesses is examined below with respect to how it will perform in a period of rising interest rates.
Cincinnati Financial invests its float more aggressively than most insurers. The company has 35% of its float invested in common and preferred stock, and 65% invested in bonds. For comparison, the industry average is 18% in stocks and 82% in bonds. The company’s bond portfolio has an average maturity of 6.1 years.
Cincinnati Financial is not the safest insurer in which to invest, despite being a Dividend King. The company’s combined ratio is troubling. The combined ratio is an insurers claims paid plus operating expenses dividend by premiums collected. When the combined ratio is below 100%, it means the company is writing profitable policies.
Cincinnati Financial’s combined ratio is currently around 95%. While not great, the company is currently writing profitable policies. Unfortunately, for much of the last 7 years the company has maintained a combined ratio over 100%. Cincinnati Financial is having to subsidize its operations with income from its float.
When interest rates rise, Cincinnati Financial will be able to invest new premium income into higher yielding securities. The company’s higher-than-average exposure to equities and its high combined ratio make the company a mediocre choice for an investment hedge against rising interest rates.
Chubb Corporation has paid increasing dividends for 33 consecutive years. Chubb is among the highest quality insurers. The company has maintained a combined ratio under 100% every year since 2002.
Chubb posted a combined ratio of 93.9% in its most recent quarter. Excluding the impact of catastrophic events, the company’s combined ratio was 85.8% in its most recent quarter.
Comparing Chubb’s investment portfolio to Cincinnati Financial’s reveals much about the company’s risk tolerances. Chubb Corporation has 92% of its float invested in bonds and short-term investments. The company has only 5% invested in equity securities. Cincinnati Financial takes significantly more risk in volatile equities than Chubb. If the stock market were to all significantly, Cincinnati Financial’s investment portfolio would be severely affected, while Chubb’s would not.
Chubb Corporation is an exceptionally high quality insurer. The company stands to benefit from rising interest rates. When interest rates rise, Chubb will be able to invest new premiums into higher yielding debt securities. The company currently trades at a price-to-earnings ratio of just 11.7 and has a dividend yield of 2.3%. Chubb’s combination of low price-to-earnings ratio, long dividend history, and safety make it a long-time favorite of The 8 Rules of Dividend Investing.
AFLAC is the global leader in cancer insurance. The company generates 75% of its premium revenue in Japan, and 25% in the United States. Due to its large exposure to Japan, AFLAC has unique risks.
AFLAC was founded in 1955 and has paid increasing dividends for 32 consecutive years. The company’s longevity and stability should appeal to long-term investors.
AFLAC is among the most profitable and well run insurers. The company’s combined ratio is currently 81.1%. The company’s combined ratio has been well below 90% for the last decade. AFLAC’s extremely low combined ratio shows the company writes low risk policies that are priced very comfortably.
Since AFLAC has the bulk of its operations in Japan, it tends to invest in Japanese securities. Currently, 38% of the company’s investment portfolio is in Japanese government bonds. AFLAC holds virtually no equity securities and invests almost entirely in fixed income investments. The company stands to gain significantly when interest rates rise. AFLAC will be able to invest the significant premium flows it generates into higher yielding securities, which will boost income.
Insurance rates are likely to rise. The exact timing of the increase is unknown, but the Federal Reserve is signaling they are strongly considering raising interest rates soon. When interest rates rise, dividend stocks will not be harmed significantly. The utility sector has the most to lose from rising interest rates. Low risk insurers will likely be the biggest benefactors of rising interest rates.