Keep an eye on income investments

On August 22, Federal Reserve chair Janet Yellen revealed a little more about her position on interest rates. Speaking at the annual meeting of global central bankers, she said while the economy is “making considerable progress,” she’s still keeping a close eye on America’s slowly recovering labour market.

Although she made no specific mention as to when rates will rise, her words suggest that she’ll be patient, but not more patient than she needs to be. Experts say if employment picks up speed she may increase the overnight rate, which has been close to zero since December 2008, earlier than expected.

Every investors should pay attention to Yellen’s speeches, especially those who have a high concentration of income-yielding stocks. When rates eventually rise—many people think by mid-2015—dividend-paying stocks could suffer.

Essentially, as higher-yielding bonds start to become more attractive, stocks, which are a more volatile asset class, become less enticing.

We may be a year away from an interest rate move in both the U.S. and Canada, but investors should take a hard look at their portfolios and make some moves in anticipation of rising rates.

“Rates are definitely going up,” says Rob Edel, chief investment officer at Vancouver-based Nicola Wealth Management. “And stocks will start to discount that before it happens.”

Interest rate sensitivity

After the recession many investors jumped into high-yielding sectors such as REITs and utilities, says Edel. Since interest rates were so low—and still are near record lows—investors had to find income in equities.

Now, though, there are many portfolios that have a higher concentration of these interest rate sensitive sectors than they should. If bond rates rise and REITs and utilities suffer—we saw them fall by 16% and 12% respectively when 10-year bonds rose in the summer of 2013—then whole portfolios could be impacted.

Every advisor should be reviewing their clients’ income assets. Specifically look to see if there’s too much of an allocation of REITs and utilities, which have become more expensive over the last couple of years. The S&P/TSX Capped REIT Index, for example, is trading at 17 times earnings, the highest it’s been in three years, according to S&P Capital IQ.

Don’t panic, rotate instead

Don’t sell everything at once, says Edel. There are still good reasons to own REITs and utilities—both are fairly stable cash cows for one—and investors will get burned if rates rise rapidly, which no one expects them to do.

Still, there will be some volatility in these sectors going forward. If investors are too heavily weighted to overvalued interest rate sensitive sectors, they should consider selling off some of the winners and buying cheaper dividend payers, says Edel.

There are some opportunities in industrials, which tend to see higher earnings growth in a recovering economy. Canadian financials also offer strong and stable payouts, he says.

Consider going stateside too. Many U.S. financials haven’t been allowed to increase their dividends since the recession, but regulators are starting to loosen the reins. Bloomberg says eight of the 25 S&P 500 companies that will increase dividends the fastest over the next three years will be in the financial sector.

In any case, Edel says to stick to companies and sectors that have the ability to grow their earnings and their dividends. The best yielding companies to own are the ones that increase payouts at least every year, he says.

While advisors don’t have to make wholesale changes to their clients’ portfolios, it’s not too early to make a move either.

“Interest rates are going to go up,” Edel says. “We can argue how much, but people are going to have to be cognizant of the interest rate risk in their portfolio.”