2023-09-14 08:15:00 ET
Summary
- Many high yield stock prices have been beaten down due to soaring interest rates.
- However, we believe that rates are likely headed lower sooner rather than later, making many high yield stocks compelling buys right now.
- We share why we believe that rates are bound to reverse course in the near future and also discuss three top high yield dividend growth opportunities right now.
With interest rates soaring since early 2022, high yield stocks have taken a beating.
For example, REITs ( VNQ ) and renewable yield cos have taken a nosedive over concerns that interest rates are bound to remain higher for longer. However, in our view the sell-offs have been overblown in numerous cases and in this article, we will look at why interest rates are likely to reverse course sooner rather than later and share three high yield stocks that look way too cheap right now.
Why Interest Rates Are Likely To Reverse Course Sooner Rather Than Later
The case for interest rates declining in the next few years is increasingly strong due to the following factors:
- Core CPI continues to decline, with the just-released August print coming in at 4.3% year-over-year and the lag in the calculation of the housing component of Core CPI means that it is very likely to continue declining moving forward:
- The strong deflationary impact of technological innovations taking place right now - particularly in artificial intelligence - should help alleviate upward pressure on interest rates in the coming years.
- The runaway spending of governments - particularly by the U.S. - means that the Fed will likely be politically forced to cut interest rates sooner rather than later in order to facilitate continued spending without completely collapsing the U.S. budget.
- The growing likelihood of a recession means that the Federal Reserve will likely soon face a strong impetus to cut interest rates, especially with an election year coming up.
If/when interest rates officially peak and then begin to reverse course, these high yield investments should see their dividend yields compress and their valuation multiples expand once again, leading to very strong total return potential for shareholders who buy at the current bargain basement prices.
Three High Yield Top Picks
Three high yield stocks that have sold off aggressively recently and are bound to head higher once interest rates begin to fall are:
#1. W. P. Carey Stock ( WPC )
WPC's stock price has collapsed in the wake of rising interest rates, with a particularly poor performance since late January of this year:
While bond-proxy triple net lease REITs like WPC certainly deserve some sort of valuation haircut when interest rates rise dramatically as they have, we believe the current sell-off is overblown for the following reasons:
- Despite having one of the best credit ratings in the REIT sector (BBB+ from S&P), a roughly quarter century dividend growth streak, and a track record of delivering exceptional long-term total return outperformance, WPC currently trades at a 7% discount to its analyst consensus net asset value (which already factors in the expanded cap rates on its underlying properties in the wake of rising interest rates). In contrast, it has averaged a 15% premium to NAV over the past five years. This means that the market is effectively pricing in further cap rates expansion in the coming years despite the strong likelihood of interest rates declining (and therefore cap rates will likely compress as well) over that period of time
- WPC is one of the most recession resistant REITs out there, so if recession does indeed hit us, WPC will likely hold up extremely well.
- Its 6.8% NTM dividend yield is at a level not seen since the COVID-19 stock market crash and combines with its 3-4% expected same-store NOI growth in the coming years and its one to two billion dollar annual acquisition pipeline and its current discounted P/NAV valuation to provide a compelling total return profile for investors at current prices.
#2. NextEra Energy Partners Stock ( NEP )
NEP's stock price has also collapsed quite dramatically over the past year:
As a renewable yield co, the sell-off has been somewhat justified in the face of rapidly rising interest rates given that these securities behave a lot like REITs and are therefore viewed as bond proxies. Moreover, NEP has had some concerns about how it would deal with upcoming Convertible Equity Portfolio Financings. However, we believe that NEP is a compelling buy right now for the following reasons:
- Its 7.5% NTM distribution yield is at a level that exceeds even the most dramatic of the COVID-19 crash levels and is higher than at any other time in its history.
- NEP continues to guide for double-digit annualized distribution growth and has laid out a clear path to achieving it via selling its highly attractive pipeline assets sometime in the coming months, getting a IDR holiday from its sponsor NextEra Energy ( NEE ) for the next several years at a minimum, and using the proceeds from the pipeline sales, IDR savings, and retained cash flow to pay off the CEPFs and invest in a very deep pipeline of high quality pre-contracted renewable power generating assets at high (~9.5% starting) CAFD yields.
- NEP - as a provider of electrical power to mostly investment grade counterparties/utilities through long-term power purchase agreements - is a very recession resistant business that should deliver quite stable cash flows through all economic environments. In fact, a recession may even serve as a tailwind for NEP's bottom line given that interest rates would almost inevitably decline from current levels in an economic downturn, reducing its cost of capital.
#3. Enbridge Stock ( ENB )
Last, but not least, ENB - blue chip midstream infrastructure business - is now also trading at very attractive levels relative to its history:
While rising interest rates, some headwinds in Canada due to regulatory matters, and its recent issuance of equity at a fairly unattractive valuation to finance a $14 billion acquisition of some gas utilities from Dominion Energy ( D ) all somewhat justify the decline in the stock price, we believe it is likely overblown at this point for the following reasons:
- It is one of the highest quality midstream businesses in the world, with a large and well-diversified portfolio of mission critical assets, a BBB+ credit rating, and over a quarter of a century of consecutive annual dividend growth. Moreover, it has been delivering solid results consistently through good times and bad for the broader economy and energy industry, making it a great stock to hold as part of the core of a dividend portfolio.
- Its valuation is looking quite compelling right now, particularly via its 7.7% NTM dividend yield compared to its 10-year average yield of 5.5%.
- While the dilution from the new stock issuance is a bit distasteful - especially at the price it was raised at - ENB's CEO made some good points to justify the deal, namely: it cements ENB's competitive positioning in the natural gas space by making it the largest natural gas provider in the U.S. (an energy commodity that is fundamental to the energy transition), expanding its presence into new markets with friendly jurisdictions such as Ohio, North Carolina, and Utah, and ultimately may help it to grow its dividend at a faster rate over the long-term.
Investor Takeaway
The rapid rise in interest rates since early 2022 has certainly been needed to beat back multi-decade high inflation and help to clear out some froth from the economy. Moreover, the pullback in many high yield instruments was also warranted to some degree to adjust their yields for the higher interest rates. However, as is often the case, public markets tend to move too far in both the direction of giddy enthusiasm when times are good and being overly pessimistic when bearish factors rear their head.
At the moment, we believe markets are being overly pessimistic on many high yielding opportunities, including the three that we discussed in this article. As a result, we are buying many of these undervalued high yield recession-resistant opportunities aggressively right now to lock in attractive current income with the potential for strong and consistent organic growth in that income for years to come, through good times or bad.
For further details see:
Buy The Dip: These High Yield Dividend Growers Are Way Too Cheap