Banking & Finance

Rising Interest Rate Risk For Big Dividends, Sector By Sector

The bull market appears to still be alive and well for equities, but the risk of rising interest rates is plaguing bonds and investments tied to big dividends. What equity investors also need to know is that this same risk is also taking the values and above-market premiums out of many of the top go-to sectors that high dividend yield investors have been hiding in for the last two years. Utility stocks, MLPs, banks, MBS REITs, and defensive stocks have seen the wind come out of their sails as investors are becoming more concerned about rising Treasury rates. Other areas such as municipal bonds, junk bonds, and diversified REITs have risks as well if the Federal Reserve starts tapering bond purchases sooner than expected.

We have featured many sectors this week for a rising interest rate risk group. Dividend investors better pay attention. Some of these have what may be severe risk if interest rates rise, even if the overall equity market remains strong. The move may push some investors toward growth. Other investors will simply decide that if they can make a half-point or full point higher in Treasury yields without the equity market risk then they will take that. We already saw that investors would suddenly chase higher interest rates in this week’s Treasury note auctions.

Not all banks will flop under higher or rising interest rates. Banks generally just have to avoid inverted yield curves. One analyst report from the team at Merrill Lynch went on to show that Wells Fargo & Co. (NYSE: WFC) and others would win in higher rates, while others would lose. That full list is here.

Before looking further, we did issue a primer in the recent days that is meant to act as a How-To Guide on how to short Treasury bonds. If the next great short is bonds there are ways that Joe Public can make money just like the hedge fund managers.

The high payouts from the Master Limited Partnership sector are considered to be at risk by some investors, although the risk is likely an asset preference risk by investors more than a serious business risk. Deutsche Bank gave a list of the safer MLPs, showing that Enterprise Products Partners L.P. (NYSE: EPD) topped its list. We would caution that JPMorgan Alerian MLP Index ETN (NYSE: AMJ) tracks this broad sector and it has been in a downward trend for almost two weeks and is down close to 10% from its recent highs. There may be value when the dust settles, but investors often shoot first and ask questions later.

Mortgage REITs face a dual risk at the current time. Rising rates creating duration risk is one thing, but low prepayments and a low supply of conventional mortgage-backed securities is another. Annaly Capital Management, Inc. (NYSE: NLY) is considered one of the best of the MBS REITs and it screens out having a 12.5% yield. To show just how bad the rate risk is here, Annaly shares have rallied only once in about two weeks and that rally was so small it was unnoticed. Investors can also look at the close to the same trading pattern in the more diversified Market Vectors Mortgage REIT ETF (NYSE: MORT). Oppenheimer has loosely defended some of the players in this sector but the verdict remains out.

One of the biggest risk sectors is in electric utility stocks. Investors used to use these as the new equivalent of CDs, but higher rates mean that the long-term borrowing costs go much higher to finance long-term power projects that may have a life of 30 to 40 years. The Utilities Select Sector SPDR (NYSE: XLU) may have finally stabilized, but this was down almost 10% from the highs at the start of May. FirstEnergy Corp. (NYSE: FE) was hit hard with an analyst downgrade this last week and shares have not recovered much, leaving it with a dividend yield back above 5%.

Drug stocks are supposed to be safe havens as well. Pfizer Inc. (NYSE: PFE) has performed poorly in recent days and shares are now down 10% from their recent highs. Merck & Co. (NYSE: MRK) has still held up well likely because its yield is higher at 3.6%. Procter & Gamble Co. (NYSE: PG) has now pulled back more than $5 from its $82.54 high even though the activists succeeded in getting its CEO out of the picture. Its yield is about 2.9%, but investors are staying away as P&G still trades at almost 20-times earnings.

We recently reviewed that Sterne Agee went out defending the homebuilder sector. While this group is not known for paying out high dividends at all (or any dividends), housing is of course very prone to being interest rate sensitive. PulteGroup, Inc. (NYSE: PHM) was defended in this call, but the entire group remains at least at some risk here even as housing markets are recovering.

Perhaps the ultimate risk in rising rates, or at least a huge unknown, is gold. Gold has been battered and has lost its reserve currency alternative status for investors after a 12-year bull market. What is interesting is that despite the risks in being a miner is that the mining stocks got back to 2008 or 2009 levels and have become so cheap to gold that value investors have to at least given them a review.

Are interest rates going to rise as fast as the worst case scenario? Probably not, but when rates do reverse the easy-money status that has been in place for years you can bet that the move higher will be much more than just the 50 basis points or so that you have seen in recent weeks.

Keep in mind that a rising interest rate environment is not likely to make companies decide to stop lifting their dividends. What may change is that investors will become much more selective about their dividend investments, and they may avoid some of the sectors which had been in so much favor for dividend lovers of late.