With interest rates set to rise, income investors – those who invest in bonds and dividend paying stocks to generate income for life expenses – are justifiably worried. The secret for staying calm in such times is to have an effective and consistent investing strategy and to stick with that strategy regardless of what outside forces do. In the last post I discussed what the effect of rising interest rates is on income investments. Today let’s look at how to invest if you’re an income investor whee rates are rising. Let’s first look at the effect changes rising interest rates will have on bonds and dividend paying stocks and then see what the appropriate investment strategy would be.
Bond and Rising Interest Rates: If you hold individual bonds, you can be sure that their prices will decline if interest rates increase. The change in price will be proportional to the increase in rates. If you hold bonds to maturity, however, you can expect to be paid whatever the bond payoff is when the bond matures regardless of price fluctuations in the interim. For most bonds, this will be $1000 per bond. So if you hold a bond right now that is worth $900 per bond (the price is $90) and interest rates increase, the price may drop to $80, or $800 per bond. If you hold it until it matures, however, you should get $1000 per bond. The only exception would be if the company defaults on the bond, in which case you would get next to nothing.
If you hold bonds in a mutual fund, the mutual fund will see similar things happen to the bonds they have, which will cause the price of the fund to decline somewhat, but then new bonds they buy will pay a higher interest rate, so that their payouts will increase, possibly leading to the price of the fund to increase again. The farther out the maturity date of the bonds they hold, the greater the change in price you should expect. For example, a long-term bond fund may decline quite a bit, but a short-term bond fund may not decline at all. This is because the long-term fund holds bonds that won’t mature for many years, while the short-term fund has bonds that mature within only a few years, so investors are more focused on the price of the bond relative to its maturity price than they are on the interest rate paid by the bond. They are almost assured of being paid whatever the maturity price is within a year or two, but won’t collect many interest payments before the bond matures.
In either case, if you are a long-term investor, your main concern should be more about the income you are receiving and the risk of default than you are of about the price of the bonds or of the fund that holds them. If you are going to hold the bonds until maturity anyway, or hold the fund until the bonds the fund holds mature, it really won’t matter if the price of the bonds decreases for a while. If you are a regular investor, you should enjoy the opportunity to pick up more bonds cheaply and get a greater interest rate for your investment.
Note that if you are thinking of selling out and then buying in at lower prices, the prices of bonds and their funds already reflect the expected interest rates. You would just be paying transaction costs and taxes. You would also be forgoing interest payments while waiting for bond prices to drop and interest rates to rise.
Dividend Stocks and Rising Interest Rates: The effect of rising rates on stocks is similar to that on bonds, but slightly different. This is because there is no maturity for a stock – you have no assurance that you will receive any amount for your shares in the future – and because the dividend a stock pays can change over time. While the price of dividend paying stocks may rise and fall as interest rates fall and rise for the same reason as do bond prices, every high yielding stock will act like a long-term bond since there is no “maturity date” in the future. The average price of the stock will be based on whatever dividends the company is able to generate in the future with either a premium or a discount depending on what interest rates are doing.
In finding dividend paying stocks, it is therefore important to select those that have stable dividends. You don’t want to pick one that is paying out so much as a dividend that there is not enough money left over to reinvest in the company. Note that if a company is paying a much higher dividend than its peers – for example, one utility is paying 10% while all of the others are paying 5%, the dividend is probably not sustainable and therefore will be cut in the future. Often the reason that the dividend is so high is that the price of the stock has dropped in anticipation of the company making less money and therefore needing to cut the dividend.
Finding stocks that have consistently grown their dividends, such as those that have increased their dividend for ten years or more, is generally a good strategy. This shows that the company is well run, growing, and is willing to reward investors with a portion of the profits they make. If you’re holding that kind of stock, while the price may drop in the near-term if interest rates rise, over long periods of time you’ll probably be just fine. Just focus more on the amount of the dividend being paid and less on the price of the stock. If you’re not ready to sell soon anyway, the stock price really doesn’t matter much.
When to Start an Income Portfolio
While there is no reason to sell bonds and high yield stocks just because you think interest rates are going to rise, buying such assets when interest rates are at historic lows, as they have been for the last several years, is not a good strategy. You are effectively locking in your rate, especially when you buy a bond and to a limited degree when you buy a dividend paying stock. Because rates went so low, many bonds went above their par value, meaning that if you buy them now they’ll drop in price when they mature and you won’t get your full investment back. You also may be locking in a 4% return when you could get 6% or 8% for the same bonds in a better environment. In this type of environment, it is better to hold growth stocks and simply sell shares to raise income as needed. Note that the taxes are often lower on capital gains than on interest income as well, but this varies over time and by state.
You should start an income portfolio when interest rates are high, relative to historic rates, and there are therefore many bonds of quality companies paying a good interest rate and solid dividend paying stocks paying a good yield. You also want to buy a portion of income stocks and bonds that are appropriate for your stage in life. If you need regular income because you’re going through college or in retirement, you’ll need more income paying assets than if you are working a regular job and have many years before you’ll need the income.
You might consider putting a portion of your portfolio into income securities even if you don’t really need the income and will just reinvest since that will help add stability. This means that your portfolio value will hold up better during various recessions and bear markets in stocks. Over the long-term you’ll be giving up return, however, so if you still have a really long time horizon, you might choose to forgo the income investments. If you do buy some bonds and dividend stocks and don’t need the income, however, put them in your traditional IRA or 401K so that you won’t be paying taxes on that income each year, allowing your investments to compound and grow.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.