What do you get when you combine record corporate profits, a record high stock market, a threat of a taper and no inflation?
The end of zero interest rates.
Let me begin by telling you that rising interest rates are not such a bad thing. Rising interest rates typically accompany an improving economy: more jobs, more demand for goods and services and a better outlook for corporate profits. This is still a Goldilocks environment for stocks. Even though we have recently seen a sell-off in high-yield stocks and REIT’s, this is not the time to sell those investments.
One can argue that an income-oriented dividend paying stock, like a pipeline, utility or a bank could be valued based on the spread between its dividend yield and the interest yield offered by a risk free product. A dividend paying stock that has a history of regularly increasing its dividend and has a reasonable payout ratio, valuation and balance sheet should have a dividend yield of at least 75% of the 10 year risk-free interest rate offered by a government bond. If the risk-free rate is 5%, it would be reasonable to receive a dividend yield of 4% from an income-oriented stock.
You will receive a lower income stream in the interim from the stock, but you should be compensated in the long run for holding the equity. In Canada, the dividend tax credit makes dividends much more attractive on an after tax basis. Given that the 10-year government of Canada bond is offering 2.05% today, it doesn’t make much sense to sell your shares of National Bank yielding 4.8%, TransCanada, yielding 3.8% or Pembina Pipeline at 4.9%. Even if interest rates rise to 5%, these stocks would still be attractively valued at today’s prices.
A similar rule of thumb can be applied to real estate investment trusts (REIT) investments. REIT’s should offer a yield at a rate of 2 times the 10-year risk free yield. At 2.05%, a good quality REIT should pay you about 4%. REIT’s are less attractive than dividend paying equities; they are limited in their ability to raise their distributions, and they have high payout ratios and less enviable balance sheets with no benefit from the dividend tax credit. Many of our favourite REIT’s yield well in excess of 5%, including H&R REIT at 5.7%, Crombie REIT At 5.8% and Northwest Healthcare Properties REIT at 6.3%. While still attractive today, REIT’s face more risks that dividend paying stocks in a rising rate environment.
We must remain cognizant of the risks, but it seems premature to fear the recent move up in short-term interest rates. While we recommend that your portfolio include defensive income oriented stocks, you must keep a balance and own companies that will do well in a rising rate environment
Disclosure: The author and/or household family members own shares in National Bank, Northwest Healthcare Properties REIT and Pembina Pipelines.
Clients of Baskin Financial own shares in all companies mentioned in this post.