The final meeting of the Federal Reserve on Dec 16 is sure to cook up a storm as it will likely result in an interest rate hike for the first time in almost a decade.
Notably, in a speech to the Economic Club of Washington, Fed Chairperson Janet Yellen articulated her confidence in the U.S. economy. Further, Yellen advocated that the two requirements for a Fed rate hike, i.e. enhancement in labor market and an increase in inflation have been achieved.
Rate Hike Effect
However, the looming rate hike raises a vital question: How will the rising interest rates impact dividend-yielding stocks?
The common opinion of income investing is that this investing spectrum underperforms in a rising rate environment as the benchmark Treasury bond yields start to ascend. Thus, investors tend to dump high-income securities in such a scenario as they are expected to lose some of their sheen.
However, investors should note that dividend investing is still in fine fettle. This is because volatility levels are liable to flare up once the U.S. economy shifts from a loose to a tight monetary era and some market corrections look inevitable, though just for a while.
The dividend earned from such securities should then act as a hedge against economic uncertainty, making up for the likely capital loss and provide downside protection through substantial yields on a regular basis. Further, dividend stocks are generally less volatile than non-dividend stocks and proven long-term outperformers.
Finally, though the Fed is highly expected to turn hawkish in December, it constantly asserts that it will opt for a slow rate hike trajectory making dividing investing a not-so-downbeat area in the coming days. Even if the yields rise ahead, investors may look for benchmark Treasury yield beating options that offer decent capital gains in a choppy market.
Meanwhile, against the general view, dividend growers have historically performed well when inflation and interest rates rise. In fact, according to data compiled by Ned Davis Research, three years post the first federal funds rate hike by the Fed, dividend growers outperformed non-payers by more than 17% points.
Is Everything at Stake?
The idea of higher interest rates can be a tad bit scary for investors. Also, one needs to understand that rising interest rates are a double-edged sword!
Accelerating economic growth often leads to rising interest rates, simultaneously increasing the cost of debt capital. When rates begin to climb, share buybacks reduce, which in turn weakens price support for several stocks.
However, on the whole, an improving economy is clearly a boon for the overall stock market and thereby has a stronger impact than low borrowing costs.
Fortunately for investors, there are plenty of sectors and areas of the economy where a rate hike would in fact be welcomed news. Nevertheless, some of the stocks will outperform while others will lose value, so it is important to wisely choose the sector before investing.
Thus, instead of losing sleep over the Fed rate hike, it is now time for investors to readjust their investment portfolios in order to benefit from the potential reversal of the interest rate environment. The finance sector, in this regard, seems to be a good bet, as several of its industries tend to benefit from rising rates.
Finance: Why Is It a Good Bet?
Banks, insurance companies, discount brokerage firms and asset managers have been clamoring for higher interest rates as the widening spread between short and long-term rates bolster profits for them.
Banks gain from a steep yield curve, i.e. when the spread between long-term and short-term rates is wide. The interest rates on deposits are typically tied to short-term rates while loans are often tied to long-term rates. Thus, the potential rise in rates will allow the banks to charge more for loans, leading to an increase in the spread between lending rates and the rates paid on deposits. Further, an improving economy means that credit quality will likely improve, which will also aid banks' profitability.
Insurance stocks benefit the most from a rate hike. That is because insurance firms must match up assets (bonds) with their liabilities (policies), so higher rates mean more investment income. With more income and similar policy payouts, insurance companies witness an improvement in margins, making them top picks in a rising rate environment.
With a rise in rates, brokerage firms are expected to engage in more investment activity. Notably, brokerage firms earn interest income on un-invested cash in customer accounts. The rise in rates will thus enable the brokerage firms to invest at higher rates.
Further, asset managers can position themselves favorably with the rise in rates. In the fixed income sector, default rates are likely to plummet and higher interest rates will allow reinvestment at higher yields, which will eventually boost portfolio returns. The benefit can be attained by positioning fixed income portfolios strategically through proper management of duration, diversification of sources of yield and maximize the reinvestment of income.
5 Stocks to Invest in
Keeping the above factors in mind, with the help of the Zacks Stock Screener, we have zeroed-in on five stocks from the finance sector with a dividend yield of 2.5% or more and a Zacks Rank #1 (Strong Buy) or 2 (Buy).
Here's a look at five companies that are currently well positioned to gain from a rate hike:
Cincinnati Financial Corp. CINF engages in the property casualty insurance business and is among the top 25 property and casualty insurers in the U.S. The company has been benefitting from an above-industry average premium growth, expansion in underwriting margins and excellent performance of its diversified investment portfolio. It currently provides an annual dividend yield of 3.02%
Going forward, this Zacks Rank #1 company’s low leverage, ample capital, consistent cash flow generation, favorable reserve release, share repurchases and consistent dividend hikes should drive growth. Further, for full-year 2015, EPS is expected to improve a healthy 25.6%.
Woori Bank Co., Ltd. WF is a financial holding company based in South Korea. It offers banking products and services to companies and individuals through its subsidiaries. Woori Bank at present provides an annual dividend yield of 5.05%
Since its launch, this Zacks Rank #2 company has achieved remarkable growth in the banking business thanks to the consolidated performances of banking subsidiaries, and continued expansion of its non-banking businesses through mergers, acquisitions and joint investments. What’s more, for full-year 2015, EPS is likely to grow an astounding 164.0%.
Chemical Financial Corporation CHFC is the second largest bank holding company headquartered in Michigan which offers strong growth and income while trading at a reasonable price. The stock has a decent annual dividend yield of 2.89%.
Strong loan growth and solid credit quality lends more optimism to the stock. Also, this Zacks Rank #2 company stands to be a prime beneficiary of rising rates. Moreover, for full-year 2015, EPS is expected to grow 13.5%.
BOK Financial Corporation BOKF, a financial holding company, provides various financial products and services throughput Oklahoma, Northwest Arkansas and North Texas. BOK Financial has an annual dividend yield of 2.54%.
This Zacks Rank #2 company’s diverse revenue mix and favorable geographic footprint should support its growth, going forward. Moreover, the company maintains a strong capital position. Announcement of enhanced capital deployment activities, including a dividend hike, should further boost investors’ confidence in the stock. Further, for full-year 2015, EPS is expected to grow 1.6%.
Aflac Incorporated AFL is a leading provider of individual guaranteed-renewable health and accident insurance in Japan and the U.S. The company currently offers a dividend yield of 2.51% and is poised to gain significantly from the impending rate hike.
This Zacks Rank #2 company’s diversified business mix in the life insurance segment, steadily growing retirement plan business and Annuity business places it well for long-term growth. Moreover, Aflac has maintained strong capital levels which allowed it to buy back shares and increase dividend payouts at regular intervals to boost shareholder’s wealth and confidence in the company.
Cash In
Though the stakes are high, there is considerable scope in the market for those who are willing to gain from the shift in the economic dynamics during the rising interest rate environment.
Investing in stocks that pay dividends is a brilliant way to build wealth over time, however, picking the right dividend-paying company is extremely important. Moreover, given the present scenario, it is equally imperative to pick the sector carefully before taking the plunge.
Thus, investments in the above-mentioned dividend yielding stocks from the finance space should prepare you for the rate hike by making changes in your portfolio before the rate hike gets fully priced in.
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