Make Money in Any Sector with Increasing Rate Hikes
Interest rates have been moving up, and it looks like they will continue to do so.
In fact, the latest May employment report was very positive and all but guarantees the Federal Reserve will hike rates again when it meets on June 12th and 13th.
Beyond that, many market watchers are expecting two more hikes before the year is over.
That could take the Fed’s benchmark interest rate target all the way up to a range of 2.25% to 2.5% by January 1, 2019.
So a natural question is how continued rate hikes might affect some of the investments and strategies I favor.
Let me start by saying that higher interest rates are great news for conservative investors and savers.
At the same time, there is no doubt that lots of portfolios could get hurt along the way.
I continue to believe fixed-income investors have the most to fear, especially if they’re holding longer-dated bonds. But I won’t pretend that dividend stocks are entirely immune.
We’ve already seen a little air come out of higher-yielding shares over the last several months.
For example, the S&P 500’s utilities companies are down almost 4% year to date (including dividend payments).
Utilities tend to get hit harder than most by rising interest rates for two major reasons:
Reason #1: Rising rates crimp their corporate finances.
For the most part, regulated utility companies, offering specific and tangible services, charge set rates — fixed by state and municipal governments. So that means their income is pretty much set in stone at the start of their rate period.
At the same time, their operations are very cost intensive and depend on lots of borrowed money. As rates increase, their ability to take on new debt for expansion and improvements decreases.
The end result is a strain on their cash flows and profitability.
Reason #2: Their dividend yields become less competitive.
As interest rates go up – and we see higher yields on CDs, money markets and bonds – investors have less need for dividend stocks.
This is obviously true across the board, but it’s especially true of utilities. After all, they aren’t known for big, fast capital appreciation. If anything, they’ve always been called “widow and orphan” stocks because they act more like bonds than equities.
Of course, I am not saying you should abandon all your utility shares.
To find out if your utility holding will hold up under the pressure of rising interest rates, make sure the company has a solid cash position compared to its current debt.
If a company needs to issue more debt or head to the stock market to raise capital for expansion and operations soon, it will be the first to suffer when rates go up.
A great little ratio you can find on most financial quoting websites – or your broker’s site – is the “quick ratio.”
Basically, this measures how much cash and short-term securities a company has in comparison to its near-term liabilities.
The actual formula is: cash + short-term securities + receivables divided by current liabilities, like short-term debt.
This gives you a sense of how much near-term liquidity a company has at its disposal if rates were to suddenly rise.
The higher this number is, the better. So anything over a 0.8 or 80% (depending on how your preferred site lists it) should give the company enough room to work in the short term.
The second number you can look at to tell if a utility is positioned for a rate hike is its long-term debt to equity. I’m using long-term debt, since we already accounted for its short-term debt coming due with the quick ratio.
As the name suggests, long-term debt to equity gauges how much debt a company has compared to its equity, or book value.
Basically, it shows you how much financial leverage a company has used. A higher number means a company is more leveraged, which is a bad thing if rates are rising.
So you want to look for a LOWER long-term-debt-to-equity number. Anything under 0.8 or 80% is good.
Of course, since utilities are such a special type of business, it may be okay to make an exception for a company with a ratio as high as 1 or even 1.1 (100% or 110%) if it has other factors in its favor.
One last thing to remember is that quality dividend companies – including utilities – have the ability to continue increasing their dividend payments as time goes on.
So they have the potential to hand out ever-increasing streams of income over the long-term.
That’s one of the primary reasons I will ALWAYS recommend them for retirement portfolios, even as interest rates start rising more sharply.
To a richer life,
Editor, The Rich Life Roadmap