Threat of rising rates can be countered

(July 22, 2005) Conservative investors may be getting nervous in the current environment, with central bankers promising to raise interest rates and equity markets seemingly priced to perfection. Higher interest rates could stifle an equity rally while wiping out the premium valuations on existing fixed income products.

But fund managers at the Franklin Templeton Outlook and Opportunities Forum say the risks can be managed through careful scrutiny of income investments.

Juliette John, lead manager of the Bissett Dividend Income Fund, admits that equity markets are a “little bit pricey”, with a market valuation of about 17.5 times earnings. But she says dividend paying stocks are still a valuable tool in income investing, so long as investors choose carefully among the numerous blue chips offering these cash payouts.

“We think it’s more reasonable to pay very close attention to how much we’re paying for equities at the outset, in order to protect capital,” says John. Earnings increases in equities should be cut in half for the coming year, though she still predicts growth of about 15%. “We see a lot of that earnings increase concentrated in the materials group, the energy sector and even IT.”

Dividend stocks tend to be relatively safe, as far as equities are concerned, in both up markets and down markets. The dividend increases are fuelled by higher profits in a strong economy, while downturns generally send investors running to so-called “quality” stocks. As an example of such strong stocks, John points to financial stocks, which are paying dividends close to 80% of their bond yield.

The best companies are those with the ability to increase their dividend on a consistent basis. These increased payments not only put more cash into the investor’s pocket, but they usually increase the stock’s value, as the share price is bid higher to maintain the yield. A stock with a dividend yield of 4% will tend to rise in value if a dividend increase moves the yield to 4.5%, assuming the other fundamentals of the company remain sound.

“The focus on companies that have solid growth and dividend potential is really going to protect a lot of value,” she says. “Typically price to earnings multiples tend to get compressed as interest rates rise, so focusing on companies with the ability to grow their payouts to shareholders will help.”

While it is commonly accepted that interest rates will rise, John’s colleagues are now predicting the increases will be smaller and more gradual than earlier thought. The threat of inflation, the oft-cited bogeyman used to justify rate hikes, has receded to the shadows in recent months.

“If inflation remains relatively well-behaved, we wouldn’t expect to see longer term interest rates increase significantly, and therefore it wouldn’t have that much impact on the bond market,” says Mike Quinn, president and CIO of Bissett, manager of Bissett Canadian Balanced Fund. Certainly if we see interest rates rising well above another couple of hundred basis points, that would have a severe impact on consumer spending, which has been driving the economy.”

He expects short-term rate hikes in both Canada and the U.S., but points out the high value of the Canadian dollar has already curbed inflation north of the border. In the U.S., productivity gains and cheap imports from east Asia have helped keep inflation under control.

“Certainly the inflation outlook tends to support a lower overall outlook on interest rates,” says Eric Takaha, senior vice president, director of high yield bonds, Franklin Advisers. There is some potential for longer term rates to move up a bit more over the near to intermediate term. “As we look at the U.S. Treasury curve, there has been a decline in the past year in the 10 year and 30 year government bonds.”

Demand for long term Treasury bonds could soon ease, however, as Washington seeks a means to finance ongoing military operations overseas as well as tax-cuts at home.

“There is some expectation that the U.S. government could start to issue longer term bonds once again,” Takaha says. “That could cause a little bit of technical pressure on 30 year bonds as we start to see more issuance.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com