Why Investors Need To Get Comfortable With Low Interest Rates & Dividend Stocks

Why Investors Need To Get Comfortable With Low Interest Rates & Dividend Stocks

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).

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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.

Source:  Author

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.

Dividend Stocks, Low Interest Rates

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.

  1. The FOMC is data driven and the data has not shown sustained growth in inflation and employment.
  2. 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.
  3. Wage growth is anemic.
  4. Other global economies are slow and/or slowing.
  5. Brexit may destabilize the global economy.
  6. 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.

Dividend Stocks, Low Interest Rates

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 the national debt each year since 2004 and the monthly interest up through July for the current year.

Dividend Stocks, Low Interest Rates

Source:  Treasury Direct

Given the previous year’s interest payments and the 2016 YTD payments, it looks like the US will pay out about $430B in interest on Treasury securities for 2016.  The average interest rate on those securities is about 2.03%  as of July 2016.

If Treasury bond interest rates were to double from here to an average of 4.06%, the debt service on the current national debt would also double to roughly $860B.  An average rate of 4.06% is still lower than we had in June 2007 (4.7%) before the last financial crisis.  Note that we have ignored the future growth in the national debt which, as shown above is climbing faster every year.  The Congressional Budget Office [CBO] estimate of the total national debt is $20.4T in 2017.  Another trillion in national debt next year would cost roughly $40.6B in additional interest at 4.06% easily raising the total interest paid out to $900B annually.

The analysis above is pretty straight forward but reality is not quite that simple.  Remember the Federal Reserve’s program called quantitative easing [QE]?

A major part of the QE program was the Federal Reserve buying Treasury securities in order to create an artificial demand which raised the price of bonds and lowered their respective yields.  Today, the Fed holds about $4.5 trillion in Treasury securities.  So, some of the interest that the Treasury pays out on its bonds, goes directly to the Federal Reserve Bank.

Our government is effectively paying itself because the Federal Reserve remits all profits back to the US Treasury.  So, how much Treasury bond interest does the Fed receive and remit back to the US Treasury?  In 2015, it was about $98B.  Using the estimated Treasury bond interest payment of $430B from the paragraph above, one could conclude that the US government’s outlay for interest on Treasury securities is only $430B – $98B or $332B.  Under that assumption, doubling the interest rate on Treasury securities would raise government outlays from $332B to $664B plus another $40.6B for growth in the national debt by the end of 2017 to a total of $704.6B.

Part of the Fed’s original plan to “normalize” interest rates includes unwinding the QE program.  Unwinding the QE program will require the Fed to sell the Treasury securities it has purchased back into the public domain.  When the Fed sells those Treasury securities back into the public domain, the effect will be to depress bond prices and raise bond yields (interest rates).

The Fed has not started to unwind QE for the same reason it has not raised short term rates.  But, eventually, the Fed will sell its holdings of Treasury securities, there will be no “rebate” of Treasury bond interest back to the US Treasury, and the actual payment of interest from the US Treasury to the public would be the full $900B based on the 2017 national debt estimate and an average interest rate of 4.06%.

That is a long way around to make the following point.  If or when the Federal Reserve unwinds QE and begins to “normalize” interest rates, the annual Federal deficit will grow significantly.  Unwinding QE alone would be responsible for increasing the current annual Federal deficit by $98B.  Raising the average Treasury bond yield (interest rate) from its current 2.03% to 4.06% would be responsible for increasing the current annual Federal deficit by $430B.

The roughly $1 trillion per year growth in the national debt will add another $40B per year in Treasury bond interest.  Can we really afford another $470B in deficit spending?  The CBO estimate for the 2016 budget deficit is $544B .  Can we afford it to be $1.014B next year and growing thereafter?

Some of our more liberal economists have written and apparently believe that one option is to simply print more money and inflate our way out of the national debt and annual deficits.  History tells us there is clearly a limit to that approach.  Aggressive money printing during the 1790’s in France led to a near worthless assignat script and contributed to the French revolution.  We are witnessing again today the results of aggressive money printing in Venezuela.  It is clear to me that simply printing more dollars is not a viable solution to the national debt and annual deficits in the US.

Closing Thoughts

The debt service payments on our national debt are already expensive.  The growth in our national debt adds to that expense every month.  The unwinding of the Federal Reserve QE program would add significantly to those payments.

A nominal increase in Treasury bond rates to the levels of 2007 would increase the debt service payments significantly and increase annual budget deficits to $1 trillion or more.  Is anyone still wondering why the Federal Reserve is reluctant to unwind their QE program and/or push interest rates higher?

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