EFFECT ON DIVIDEND STOCKS AS A RESULT OF RISING INTEREST RATES

Recently we have been asked about our exposure to Interest Rate Sensitive stocks that represent a significant weighting in all Leon Frazer portfolios. Shares of Telecommunications, Banks, Pipelines and Utilities companies are said to be inversely connected to rising interest rates, meaning that if interest rates rise these companies’ stock prices suffer. While it is true that in the very short term interest rate sensitive companies share prices can be hurt by traders playing short term moves in rates, there is little evidence that long term total returns or dividend income levels of interest rate sensitive companies are affected more negatively by rising interest rates than any other type of company.

We would highlight the following evidence to reinforce our position on this matter:

  • Interest rates are rising from extremely depressed levels which are far from competing with the dividend yields of interest rate sensitive companies – even at longer dated maturities of 5, 10 and 30 years
  • We do not expect short term interest rates (Treasury Bills, Savings Deposit Rates, Cashable GIC’s) to compete with interest rate sensitive companies’ dividend yields for quite some time
  • Our interest rate sensitive holdings are well financed and do not have large debt related funding obligations coming their way.  They have taken advantage of this low interest rate environment to extend maturities and re-finance debt obligations at lower rates.
  • Telecommunications and Pipelines holdings are expected to have steep growth trajectories that should mitigate the effect of rising interest rates
  • Utilities and Pipeline holdings have regulated assets whereby they can pass through interest rate increases to customers following a regulatory review
  • Banks have diversified businesses, some of which benefit when interest rates rise and others that are negatively impacted.  On balance we believe the banks will continue to provide solid total returns as interest rates rise due to the widening differential between which they borrow and lend funds (net interest margin)
  • Companies in interest rate sensitive sectors are continuing to increase dividends which should help to mitigate the effect of rising rates
  • LFA historical performance during the period from 1950-1982 when rates last rose on a secular basis suggests that holding a concentration of IRS stocks did not have an adverse effect on the long term annualized return for this period. In fact, our strategy outperformed the market.

 

 

 

Past returns may not be indicative of future performance.

In conclusion, we are not worried about a significant drop in portfolio values that may result from rising interest rates in the medium or long term. There may, however, be a brief period where these companies share prices decline or underperform the broader market, especially in the event of an economic acceleration and/or inflation. Over the long term these companies are set to provide the combination of current income and total return to the portfolio we desire and that is why we are maintaining these positions, even in the face of a perceived interest rate headwind. Our interest rate sensitive holdings represent the backbone of the Canadian economy and the biggest part of our disciplined investment approach is to continue to be invested in these quality infrastructure based companies regardless of short term circumstances.