CA - An Important Warning To Dividend Investors From Mr. Market

2023-10-31 13:08:51 ET

Summary

• Dividend stocks are traditionally viewed as more conservative investments due to the stability of income, historical performance, and risk mitigation attributes.
• Dividend stocks provide a steady stream of income through dividends, acting as a cushion during market downturns.
• However, Mr. Market is now sending a stern warning to dividend investors.

Dividend stocks are typically considered to be a more conservative and sleep-well-at-night approach to investing in the stock market relative to the higher-risk, higher-reward high-flying tech stocks found in exchange-traded funds ("ETFs") like the Ark Innovation ETF (ARKK) or even the Nasdaq (QQQ). However, some of that calculus is changing, with interest rates having risen so much over the past two years, particularly with the rapid rise in long-term interest rates in recent months.

In this article, we discuss why dividend stocks have traditionally been viewed as more conservative investments than higher-flying tech stocks, why that is changing, and how dividend investors can protect themselves against the emerging threat of rising interest rates.

Why Dividend Stocks Have Traditionally Been Lower Risk Than Tech Stocks

A well-diversified portfolio of dividend stocks is often considered a more conservative investment compared to tech stocks due to two key factors:

Stable Business Models: Companies that pay regular and growing dividends are typically well-established businesses with a track record of profitability and financial stability. As a result, they often have mature business models and generate consistent cash flows that enable them to pay regular dividends to shareholders. In contrast, tech stocks can be highly volatile, with future earnings dependent on successful continuous innovation and therefore leaving the stock price at the mercy of the ever-changing market expectations about future growth prospects. This more speculative nature of their business models tends to lead to rapid price swings in these sorts of stocks. Take, for example, Palantir Technologies ( PLTR ), a tech stock with a wide following that has experienced pretty dramatic market volatility since it went public a few years ago:

Dividend Yield: Dividend stocks also provide a steady stream of income to investors in the form of dividends, which can act as a cushion during market downturns. Given that investors can typically rely on these dividends as a source of income, the market often prices dividend stocks at least in part as a fixed-income substitute, thereby providing a general floor for the price of a dividend stock as long as its dividend payout is viewed as being secure. Tech stocks, on the other hand, typically do not offer much in the way of dividends, making them pure capital appreciation investments and, therefore, much more volatile.

Why Rising Interest Rates Pose A Threat To Dividend Stocks

That said, the rapid rise in interest rates is posing a threat to the notion that dividend stocks are a generally conservative place to allocate capital right now. In particular, dividend stocks with a bit more leverage on their balance sheets such as Real Estate Investment Trusts (i.e., REITs) ( VNQ ) and infrastructure and utilities ( XLU ) are seeing volatility spike. For example, consider these five stocks that all boast credit ratings of BBB+ or higher from S&P and have long been considered the gold standard blue chips:

NextEra Energy, Inc. ( NEE ) : Despite being widely viewed as the creme de la creme in the utility sector with a robust growth pipeline, a solid balance sheet , and an impressive dividend growth track record and outlook, NEE's stock has been incredibly volatile lately (alongside its renewable power yield co subsidiary NextEra Energy Partners ( NEP )) as long-term interest rates have spiked:

Brookfield Infrastructure Partners ( BIP , BIPC ) : Long considered to be the pre-eminent global infrastructure investment that also has a very impressive track record of growing distributions at a high single-digit CAGR for over a decade alongside an attractive current yield, BIP has seen its price tank in response to soaring interest rates despite maintaining solid business fundamentals:

Brookfield Renewable Partners ( BEP , BEPC ) : Like its sister BIP, BEP has long been considered the pre-eminent global renewable power production investment that also has a very impressive track record of growing distributions at an attractive CAGR for over a decade alongside an attractive current yield. However, BEP too has seen its price tank in response to soaring interest rates despite maintaining solid business fundamentals:

Enbridge Inc. ( ENB ) : ENB has arguably the most impressive dividend growth track record in the entire midstream sector and also offers investors a compelling dividend yield. Moreover, between its BBB+ credit rating, nearly 100% exposure to either utility-like regulated or long-term contracted high-quality assets, and nearly 100% exposure to investment-grade counterparties, ENB is one of the most conservative high-yield infrastructure investments available to investors. That said, its stock price has not escaped the effect of rising interest rates either:

Realty Income Corporation ( O ) : Last, but not least, O - otherwise known as "The Monthly Dividend Company" - has long been widely regarded for its remarkably consistent cash flow and dividend per share growth over the course of several decades. The triple net lease real estate investment trust, or REIT, continues to churn out steady growth and is very well positioned to weather an economic downturn, yet its stock price has tanked this year, losing nearly one-third of its value so far in 2023:

Why are all of these stable, high-quality, dividend-growth businesses taking such a beating from rising interest rates?

1. Increased Borrowing Costs: As interest rates rise, the cost of borrowing money also goes up. This is particularly problematic for leveraged companies like REITs and infrastructure businesses, which typically use debt to finance asset purchases. Given that these businesses have already built up large asset portfolios with debt that was financed during a period of historically low interest rates, as this debt matures in the coming years, they will likely see their interest expense soar, eating into the profitability of their existing assets as well as weighing on spreads in future growth investments. While the aforementioned strong businesses are unlikely to face financial distress from having to refinance debt at higher rates, their profitability will still likely face at least some headwinds, even if it just means a reduction in their expected growth rates.

2. Valuation Pressure: An additional reason why these stocks are likely selling off in the wake of rising interest rates is that, when interest rates climb, fixed-income investments such as bonds ( BND ) become more attractive to investors because they offer higher yields with less risk compared to dividend stocks. As a result, the opportunity cost of holding dividend stocks increases because investors can earn higher yields from fixed-income investments without the inherent volatility of stocks, leading to falling demand for dividend stocks and a corresponding drop in their valuations. Moreover, rising interest rates can lead to downward pressure on the valuation of these stocks as the discount rate used to value them increases in tandem with rising interest rates, thereby reducing their present values.

Investor Takeaway

While dividend investing has been a fantastic way to build wealth over the long term, investors need to heed the important warning that Mr. Market is sending in its treatment of some of the leading names in key dividend sectors: rising interest rates are a powerful headwind for even the best of real asset businesses' dividend growth ambitions.

How should investors respond to this threat? Here are a couple of suggestions:

1. Double down on attractive opportunities to buy great businesses at wonderful prices. Each of the five businesses mentioned above is phenomenal in nature and not only profited from cheap money but also has excellent management and high-quality assets. With strong credit ratings and balance sheets, we expect them to weather higher interest rates well and will likely come out of this period of elevated interest rates stronger than ever. As weaker peers crumble under the weight of elevated interest rates, these businesses will be in a prime position to potentially buy up discounted assets on the cheap.
2. Diversify intelligently into sectors that profit from higher interest rates. In particular, floating-rate fixed-income securities, insurance stocks and certain other financial stocks, short-term treasuries ( SGOV ), and Business Development Companies ("BDCs") are all great ways to generate high levels of income from stocks that benefit from higher interest rates. This way, if interest rates end up falling, the aforementioned REIT, utility, and infrastructure stocks should likely recover sharply. However, if interest rates continue to remain at elevated levels or even rise further, the floating rate fixed income securities, insurance stocks, and BDCs should outperform on a relative basis.

This is the approach that we are taking and expect it to help us continue enjoying significant total return outperformance along with attractive current income over the long term.

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