Profit from rising interest rates

Dividends have always been a significant component of total returns – anywhere from 28% to 50%, except in the 1990s. And as bond yields have fallen, investors have looked to dividends for returns.

There will probably be a long-term interest rate rise soon, predicated on the end of quantitative easing in the U.S. Even rumours of Fed tapering saw some dividend sectors sell off, most prominently North American REITs.

“REITs are sensitive to rates because they have a fair amount of leverage, which is fine because they have long-term leases,” notes Jason Gibbs, a portfolio manager at GCIC Ltd., which manages Dynamic Funds.

But don’t dump REITs. “Over time, real estate has been a good inflation hedge, because if rates go up, that means economies are growing and rents and occupancy should be going up,” he adds. “But you do have to own ones that have some sort of growth.” Look for strong balance sheets and market dominance. On the other hand, fiercer competition, which could lead to elevated vacancy rates or discounted rents, may result in a distribution cut.

Read: 3 reasons REITs will outperform

Many bond substitutes are in regulated sectors of the economy, such as utilities, pipelines and low-beta consumer staples, says Naveed Rahman, an institutional portfolio manager at Fidelity Investments in Boston. Utilities, for example, showed an 80% correlation with 10-year Treasuries over the last 18 months. Historically, that correlation has been below 60%.

As a consequence, he says, “there’s a lot of valuation risk in those stocks should rates increase.” That’s because sector dividend yields and payout ratios are both high. For a utility with an 85% payout ratio, a 4% dividend yield and higher-than-usual valuation, if rates move by 80 to 100 basis points, there’s little room to boost the payout ratio. Unless the company is growing, the stock price is at risk: an investor can earn a risk-free rate around 3.5% to 3.7%, making utilities overvalued. In Spring and Summer 2013, when long-term interest rates rose abruptly, utilities fell by 8% more than the equity market, Rahman notes.

(To put payout ratios in perspective, financial companies rarely distribute more than 50% of earnings; utilities tend to pay more, because they are in a mature, low-growth sector.)

Read: What to do when interest rates rise

Some regulated companies benefit from rising secular interest rates.

“A great example would be pipeline stocks and energy infrastructure,” says Gibbs. These stocks are growing at 5% and 10% “because we’re redrawing the entire map of energy infrastructure in North America.” There are backlogs, for example, in getting light tight crude from North Dakota’s Bakken shale deposit to market, even as fracking has made oil and gas economically recoverable.

Rising rates will also be positive for financial companies, says Rahman. “Higher rates put a crimp on mortgage origination and refinancing, which for certain banks can materially affect earnings growth. On the opposite side, the net interest margin – the delta between what banks borrow at and what they lend at – gets better.”

Read: Choose shorter terms as rates rise

Rising rates work even better for life insurance companies, for the same reason they translate into better-funded status for defined-benefit pension plans. That also translates into better earnings for many industrials with large DB plans that have had to skim earnings to fund pension promises.

Explains Gibbs: “If rates go up, insurances companies often do better than banks, depending on how the yield curve shifts. Banks do well when the yield curve steepens [and] insurance companies make money investing the premiums from the policies from customers into the fixed-income market. With low rates, it’s not a good scenario for them.”

Read: Faceoff: Is costlier insurance cost-effective?

Still, the irony for dividend investors is that the sector that led the way in disparaging them – tech stocks, where Apple decided to eliminate its dividend in 1996 – is perhaps the most robust against rising interest rates.

“Most technology companies we have positions in are self-funding, non-capital-intensive businesses, so they are generating more cash than they need to keep their business growing,” says Rahman.