- Higher interest rates will increase required returns while higher debt costs will lower available cash for dividends.
- However, things vary extremely among sectors so check your portfolio stock by stock.
- The current 5% shareholder yield is unsustainable with aggregate earnings yielding 3.93%.
Things are changing!
We have been enjoying a period where yielders were in high demand as interest rates declined. However, there are two things that will have a severe impact on dividends and asset prices. The first is that low interest rates enabled companies to take on more debt and increase their return to shareholders while keeping their interest expenses low. The second is that with the Fed about to increase interest rates and the yield on the 10-year treasury note up 75% from its July low, the value of your dividend yielders is also about to collapse because stocks simply carry more risk than treasuries.
Today we’ll discuss the situation, the probabilities of different scenarios happening, and the probable impacts on your portfolio.
The Situation – A Divergence Between Fundamentals & Mr. Market’s Perception
With the exception of the Great Recession period, the dividend yield from stocks has been pretty stable in the last ten years.
Figure 1: S&P 500 dividend yield since 2005. Source: Multpl.
However, as bond yields have already inverted, sooner or later the same sentiment will transfer to the stock market as the market acknowledges higher rates, and consequently requires higher dividends from stocks. The eventual acknowledgement will inevitably lead to lower asset prices.
On top of that, inflation has also started to pick up which will make it very difficult to stop interest rate increases.
Figure 2: 10-year treasury yield and inflation. Source: FRED.
Higher interest will also increase borrowing costs for corporations and lower their free cash flows. In September 2016, the aggregate cash balance for the S&P 500 was $1.456 trillion, but the cash to debt ratio has fallen 6% year-over-year and is down to 33%, the lowest it has been since Q2 2009.
Figure 3: S&P 500 cash indicators. Source: FACTSET.
As interest rates increase, the cost of debt will also increase and thus the cash available for dividends and buybacks will shrink. Alongside the higher cash positions, corporations have also increased their debt ratios to increase distributions to shareholders.
Figure 4: S&P 500 aggregate distributions to shareholders. Source: FACTSET.
As everything that grows is bound to come back down, 2017 may be the year for distributions to decline. Total distributions in the last 12 months have been around $770 billion. With more than $7 trillion in debt on S&P 500 balance sheets, a 100-basis point increase in general interest rates would lower corporate pretax earnings by $70 billion and also remove a similar amount from the cash pile available for distributions, or 10% of the current distributions. Given that the treasury yield has jumped by more than 100 basis points from its July lows, further increases in interest rates shouldn’t be a surprise.
To conclude the general view, it’s important to know that as interest rates go up, the required return from stocks will also go up lowering stock prices. On top of that, due to the large debt levels, interest expenses will further lower distributions.
As there is a big difference among sectors, let’s discuss where to look and what to do for the best risk reward situations.
Individual Sector Overview
As you need cash for dividends, it’s good to know that the top 20 S&P 500 companies ranked by their cash holdings have 50.9% of the aggregate cash for the index. The biggest cash hoard is in information technology with Apple Inc (Nasdaq: AAPL), Microsoft (Nasdaq: MSFT), and Alphabet (Nasdaq: GOOG).
Figure 5: Cash hoards. Source: FACTSET.
Companies that have very tight cash to debt ratios will be the hardest hit by changes in the cost of debt as this tightness will force them to lower dividends to cover interest payments.
Another issue to check and avoid are the companies that spend more on buybacks and dividends than what they earn. 138 companies of the S&P 500 currently have such policies in place. Paying out more than what you earn is, of course, impossible to sustain.
The current S&P 500 earnings yield is 3.93%. However, the shareholder yield, calculated as the combination of the dividends and share buybacks, is 5%. Perhaps the higher interest payments will force companies to lower buybacks and dividends and make the shareholder yield a bit more sustainable. The issue for stocks will then be that the treasury yield will come close to what stocks yield and such a situation is again unnatural as stocks carry much more risk than treasuries.
A contrarian play is to buy into those sectors that had to cut their dividends this year. A sector to look into are miners who have suffered from low commodity prices in 2016. However, as commodity prices pick up, we can expect reinstated distributions. Vale S.A. (NYSE: VALE), the Brazilian iron ore miner, has reinstated dividend payments only ten months after the world seemed to be ending for it.
Fertilizer and food companies also look to have hit bottom, so that’s another opportunity to look into and that we’ll discuss in a coming article.
Dividends and buybacks follow sector and economic cycles, so be careful not to get caught in the wrong side of a cycle. You can read our correct forecast on REITs here, and a follow-up on the story here as an example of how interest rates impact asset prices.
Here’s what to do in your own portfolio:
- Check if a company’s dividend and buybacks are sustainable. If the company has a higher shareholder yield than earnings, the dividend might look good but it isn’t sustainable.
- Check the debt levels your dividend yielders have. Tight debt ratios will have a severe impact on dividends and consequently on asset prices.
- Choose the company that has better growth prospects as one that is a pure cash cow will fall alongside all other asset prices with fixed distributions.
- Be careful not to be in the wrong sector, especially as we are now in a seven year bull market and positive economic cycle. Things will eventually change.