The interest rate risk factor for dividend investors

Editor's note: This interview was originally published on our U.S. site, Morningstar.com, on June 13, 2014. Though the interest rate picture has evolved since then, the principles discussed here still apply today.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. Many market watchers believed that interest rates were going to rise through 2014, but instead rates have actually come down. I'm here with Josh Peters, editor of Morningstar DividendInvestor and also director of equity-income strategy, to see what this unexpected development in rates means for dividend investors.

Josh, thanks for joining me today.

Josh Peters: Great to be here, Jeremy.

Glaser: Let's first talk about what interest rates have done so far in 2014. Did you expect that rates would remain so low?

Peters: I did not. My working assumption was that interest rates would in fact continue to increase. I don't have a particular time frame in mind, but my general approach is not to think in terms of a specific macro forecast. For example, [I could say,] "I expect GDP to grow 3.2% in 2015, and therefore I'm going to structure my portfolio this way." I can't make those kind of predictions. I just don't even try.

Instead, I try to think of what are the risk factors. For dividend investors rising long-term interest rates do represent something of a risk factor. Rising rates stand to have a significant impact on some valuations in that area of the market. When I think about interest rates I want a plan on the idea that a 10-year Treasury bond might yield say 3% to 4% maybe as much as 5% in the future.

They started the year at about the 3% mark and here, a couple of months into the year, confounding everybody's expectations, we're at 2.5%. So that's generated something of a windfall gain for higher-yielding stocks. Utilities and REITs in particular have done very well in this environment. But that actually creates something of a problem. Those stocks are no longer attractively priced.

Glaser: You mentioned that you need to plan or potentially plan for rising rates. How do you do that? In a dividend portfolio are there places you can go that will protect you in a rising-rate environment?

Peters: I think it's really about two things. First is that mentally you have to be willing to accept more interest-rate risk in a high-income strategy than you would have with perhaps a more speculative strategy. I think it's a good trade-off because, yes, I take more interest-rate risk when I own lots of utilities, lots of food stocks, companies that don't respond a great deal one way or the other to changes in economic activity.

But I get a 2-for-1 bargain. Yes, I take the interest-rate risk, but I'm also taking less economic growth risk. If there's a recession my stocks stand to hold up much better than the S&P 500 Index, for example. And I also get the benefit of the income. You don't have that if you go off into other areas of the market where dividend yields are very low or nonexistent. Everything comes down to capital appreciation. I'd much rather have that stable baseline of dividend income that is providing me 3%, 4%, 5% a year of total return right off the bat. And then I can afford to let the capital-appreciation piece take care of itself over the longer run. So just having that attitude that I'm willing to accept some risk is one thing.

The other is to simply be careful with what you buy, and that in turn comes down into two categories. One is I think it's always critical to emphasize quality. You don't want to find and then own a company that might have to cut its dividend in the future for any reason. Sometimes you may find companies have problems and exposure to interest rates and might be forced to cut their dividend directly as a result of higher interest rates. What a horrible bargain that would be.

So you focus on quality; you focus on economic moat -- sustainable competitive advantages that protect the profits that in turn fund your dividends. And you pay attention to valuations. And again, not with respect to a specific forecast for the 10-year Treasury yield or the inflation rate or GDP growth or anything like that in any one point in time, but instead how does this unfold relative to my alternatives over a longer period of time?

If I pay $50 a share for a stock in today's interest-rate environment, if interest rates move from 2.5% to 4.0%, does this become a $30 stock? No matter how much you like the income, chances are you're not going to be happy if that's the outcome.

Glaser: How do you think about inflation then? That can be a wild card here.

Peters: My guess is that inflation will remain relatively low over a long period of time, but again that's an impression. If inflation remains low, then I think that benefits the economy. There's a lot of risk that perhaps inflation is too low. We could be tipping into deflation; there is a lot of controversy there. But what again is the biggest risk factor, and for me that's the idea that inflation takes off, and that central banks don't have the ability to get the horse back in the barn, so to speak.

In that case, a huge rise in inflation that would trigger, in turn, likely a huge rise in interest rates; that'd be bad for all types of securities. What I do is take some interest-rate risk with the kind of stocks that I own, but can I find those companies that can raise their dividends faster in a more inflationary environment? Can they pass through price increases to customers to make sure that the rate of growth responds to that change in inflation, so that my purchasing power of the dividends that I'm receiving isn't shrinking over time in a more inflationary environment? And Narrow and, especially, Wide Morningstar Economic Moat Ratings are a real good place to start. Those are the companies that we expect to be able to have the best shot at preserving their profitability through all types of evolving environments including an uptick in inflation.

Glaser: It sounds like your expect interest rates are still going to rise, but that it's worth taking that risk for the income stream.

Peters: Yes. I really don't know where interest rates are going to go. I mean you could talk about the beginning of this year when you have such unanimity on the outlook that interest rates were going to go up. Of course, everybody who was afraid of it had already backed out of the bond market. A lot of hedge funds and speculators took short positions and the markets have a way of confounding those consensus expectations over time. Just being able to leave your capital and your strategy intact over a long period of time, a lot of these things are just going to shake themselves out and aren't going to leave you with big gains or big losses.

Instead, let the dividends and the growth of the dividends that encourage capital appreciation over time do the work. You don't need to be a macro specialist in order to do well with these kind of stocks.

Glaser: Josh, thanks for joining me today.

Peters: Thank you too Jeremy.

Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.