Interest Rates and Income Investments

Investors who are trying to maximize their current yield may be frustrated by the lack of opportunities in the High Yield tier of our portfolio today. The tier has held only three positions since January, and until today (when I put Omega Healthcare back on Buy for risk-tolerant investors), all three have been rated Hold for several months. I hope to make a new recommendation for high yield investors soon, but there are few opportunities in the space today that meet our criteria for inclusion in the Cabot Dividend Investor portfolio.

The primary reason is uncertainty surrounding interest rates. More than six years after the Fed lowered the Federal Funds rate to 0%-0.25% in December 2008, the economy has strengthened to the point that the Fed is considering raising rates to prevent inflation. The first rate hike will be small, but the uncertainty about when it will occur is driving investors mad with anticipation. Fed Chair Janet Yellen has made clear that she won’t act until the data on economic growth, labor market tightness and inflation demand it, and of course investors can’t predict when that will be. The market despises uncertainty, and so most investments that are sensitive to interest rates have been subject to unusual fluctuations as investors try to anticipate the Fed’s next move.

Knowing how most investors feel about extreme volatility, I’ve been keeping our high yield positions—and several other interest rate-sensitive holdings—on Hold until the anticipation dims.

But how will higher rates actually affect these companies? Are investors right to dump them at the first sign of wage inflation (a harbinger of a rate increase), or are they overreacting? Below I address the impact of lower rates—and fear of lower rates, just as potent a factor—on several types of income investments.

Utilities

Utilities are affected by interest rates for two main reasons. First is their borrowing costs. Utilities have to make large investments in infrastructure like plants and distribution networks, but they have slim margins. So most borrow heavily to make investments. Because of their reliability—demand for their services is quite inelastic—most are investment grade borrowers despite their high levels of debt.

Over the past few years, utilities have been able to borrow at very low interest rates, thanks to their investment grade ratings and the prevalence of very low interest rates. When interest rates begin to rise, so will utilities’ borrowing costs.

But the change won’t affect utilities overnight. Most have wisely taken advantage of the last few years of low rates to replace their most expensive borrowings with cheaper debt, and most have locked in low rates on their debt for years. So though their borrowing costs will eventually creep up, it’s not going to happen overnight.

Interest rates also affect utilities because of something I’ll call the “substitution effect.” Over the past few years, yields on low-risk fixed income investments like treasury bonds have been so low that investors and institutions have had to look elsewhere for low-risk income investments. Utilities, with their good yields and relatively low volatility, are a fairly close substitute. Investors worry that when the Fed starts raising interest rates, institutions will flock back to fixed income and its rising yields, causing a massive selloff in the substitutes they’ve been using, like utilities.

But while we’ll certainly see this effect, it also won’t happen overnight. The Fed plans to raise interest rates slowly and in small increments, and it will take years before fixed income is competitive with equity yields. It will also take time for large institutions to reposition their portfolios. While anticipation of these effects can cause more abrupt moves in utilities—like the correction they saw in February—the effects themselves will take much longer to become apparent.

Real Estate Investment Trusts (REITs)

REITs, or Real Estate Investment Trusts, own real estate and pass the rents through to investors as distributions. We have one REIT in the Cabot Dividend Investor portfolio, Omega Healthcare Investors (OHI). REITs are negatively impacted by rising interest rates in the same ways as utilities—their borrowing costs go up, and they may become less important to investors. However, history has shown that REITs tend to outperform in times of rising interest rates anyway, for one simple reason.

Interest rates only increase when the economy is expanding, and when economic growth is strong, REITs see demand for their properties increase, and they can raise rents.

Note that this does not apply to mortgage REITs, or mREITs, which we don’t own in the Cabot Dividend Investor portfolio and which I recommend investors avoid today. Mortgage REITs own mortgages instead of property and will be decimated by interest rates increases.

Business Development Companies (BDCs)

Interest rates have largely the same effect on BDCs that they have on utilities, with one wrinkle. In addition to raising their borrowing costs and making them less attractive relative to fixed income, higher interest rates may also reduce the demand for BDCs’ services. BDCs, or Business Development Companies, lend money to and invest in small and medium-sized businesses. Some analysts argue that low interest rates create demand for their services because it makes larger financial institutions less inclined to lend to these businesses—since the yields aren’t that high. We have one BDC in our portfolio, Main Street Capital Corp. (MAIN).

Insurance Companies

We now own three insurance companies in the Cabot Dividend Investor portfolio—Aflac (AFL), Horace Mann Educators (HMN) and Maiden Holdings (MHLD). Insurers are one of the few types of income investments that actually benefit from rising interest rates. That’s because most insurers make the bulk of their money not from taking in more in premiums than they pay out in claims (although that’s also important), but from investing those premiums while they have them. But they have to invest them safely, since they’re on the hook for payout. When yields on safe fixed income investments are higher, insurers can make more on their investments without taking on any additional risk. AFL, HMN and MHLD should all begin to reap the benefits of this over the next few years.

Lastly…

While interest rates are probably the primary driver of our portfolio action today—and much stock market action—it’s important to remember their importance in context. FOMC members are now predicting a “gradual” pace for interest rate hikes, and a “normalizing” of the rate closer to 3% than the 4% we got used to in previous decades. Most experts are now calling for the same thing, revising their earlier calls for fast and furious interest rate increases.

So while interest rates will rise sometime this year or next, the increases will be moderate, will occur over time, and probably won’t go as far as most people expect. So while it’s important to keep in mind the impact higher rates will have on your holdings, it’s also important to remember that at the end of the day, not that much is going to change. A high quality company that earns reliable income and passes it on to investors is always going to be a good investment, regardless of what the Fed does and when.

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