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What You Need to Know About the March Rate Hike

- By Ben Reynolds

(Published by Nicholas McCullum on March 18)

The Federal Reserve Board increased its benchmark interest rate by 0.25% on March 15.

This benchmark interest rate is the rate that financial institutions can lend to each other overnight. Changes to this rate affect the rest of the interest rates in the domestic economy.

This is the second rate hike in three months for the U.S. central bank and only the third since the 2007-2009 financial crisis.

Many investors will wonder how this change in monetary policy will affect their investment portfolios. The following is what individual investors need to know.

The relationship between interest rates and dividend stocks

After the Fed's most recent rate hike, the policy interest rate sits in the range of 0.75% to 1.00%. The market widely expects that there will be two more rate hikes in 2017.

Rising interest rates affect dividend stocks in a variety of ways.

First of all, rising interest rates mean that companies with liabilities will experience an increase in interest expenses as they refinance maturing debt.

Thus, rising interest rates will hurt highly leveraged companies and benefit conservatively financed companies. This is one of many reasons to pay attention to leverage-related financial metrics.

Two examples of conservatively leveraged companies are:

  • Johnson & Johnson (JNJ).
  • Microsoft (MSFT).

Each of the two companies listed above holds the coveted AAA credit rating from Standard & Poor's.

There are also entire sectors that will benefit from rising interest rates due to the nature of their business models. These include:

  • Banks.
  • Payroll processers.
  • Insurance companies.

This Sure Dividend article describes the effect of rising interest rates on these sectors in detail.

The following companies will benefit from rising interest rates because of their inclusion in one of the three sectors listed above:

  • Aflac (AFL).
  • Cincinnati Financial (CINF).
  • Wells Fargo (WFC).
  • Automatic Data Processing (ADP).
  • The Toronto-Dominion Bank (TD).

Investors can also take the opposite approach. Rather than investing in companies set to benefit from rising interest rates, they can avoid companies whose businesses will be negatively affected.

Stocks that are considered bond substitutes will be hurt by rising interest rates. Bond substitute is an informal term used to describe dividend-paying stocks that are used by income-seeking investors as a replacement for bonds in a low-interest rate environment.

As interest rates rise, income investors will sell bond substitutes and purchase actual bonds since they may not want to assume the extra risk associated with equity investments. This reduced demand will lower the prices of bond substitute stocks.

Bond substitutes generally have three characteristics:

  • Large market capitalization.
  • High dividend yield.
  • Stable earnings mix/low-risk business model.

The high dividend yield is used to replace income that would normally be generated by fixed income coupon payments. The large market capitalization and stable earnings mix are seen to reduce risk (although bonds are still lower risk by definition).

Utilities and real estate investment trusts (REITs) are often considered bond substitutes because of their recurring revenue streams and above-average dividend yields. I would also suspect that high-yield telecommunications companies act as bond substitutes in the portfolios of certain investors.

The following utilities, REITs, and telecommunications companies will likely suffer as interest rates rise:

  • Consolidated Edison (ED).
  • NextEra Energy (NEE).
  • PPL Corp. (PPL).
  • Dominion Resources (NYSE:D).
  • Southern Co. (SO).
  • AT&T (NYSE:T).
  • Verizon (VZ).
  • Federal Realty Investment Trust (FRT).
  • Omega Healthcare Investors (OHI).
  • Realty Income (O).
  • Welltower (HCN).

Keep in mind that the effect of rising interest rates on the market value of these bond substitutes is not necessarily because of any fundamental deterioration in the underlying business.

Rather, prices may fall because demand for these securities will decrease as investors find similar yield (with less risk) in fixed income securities - resulting in superior risk-adjusted returns.

Looking ahead

The recent rate hike of one-quarter of a percentage point leaves the Fed Funds policy range at 0.75% to 1.00%.

There are two more rate hikes expected this year. If each of these hikes occurs and is of the same magnitude (0.25%), the year-end policy rate will sit at 1.25% to 1.50%.

While rates are certainly rising, they still sit well below historical norms in the aftermath of the financial crisis.

The Fed Funds effective rate since 1954 can be seen below.

Fed Funds Effective Rate

Source: Quandl

The current Fed Funds rate is still well below historical levels.

Looking ahead, it is highly probable that the Federal Reserve will continue to raise rates beyond calendar 2017.

Unlike cutting interest rates (which is stimulative to the economy), the Federal Reserve must be cautious when raising interest rates. If rates are raised too quickly, it could plunge the economy into a recession as borrowing costs skyrocket and consumers default on their debt obligations.

Case in point:

  • The Federal Reserve cut interest rates 10 times in 15 months during the global financial crisis of 2007-2009 to stimulate the weak U.S. economy.
  • The Federal Reserve raised interest rates in December 2015 and waited a full year before again raising rates in December 2016. Each raise was in the amount of one-quarter of a percentage point.

Imagine if the benchmark interest rate was raised 10 times in 15 months starting now - this would result in a Fed Funds policy range of 3.25% to 3.50% by June 2018 if each raise was by one-quarter percent!

Realistically, though, a 3% Fed Funds rate is closer than people think.

The Federal Open Market Committee (which makes these interest rate decisions) communicates its long-term policy goals via the Fed dot plot. The dot plot is published after each FOMC meeting and communicates the long-term projections of future interest rates from the perspective of the FOMC participants.

After the recent rate hike, here is what the dot plot looks like:

Fed Dot Plot

Source: Yahoo! Finance

The FOMC is predicting a Fed Funds rate of ~3% by 2019.

It appears that interest rates will continue to rise for the foreseeable future.

Final thoughts

In the long run, the March rate hike will have little effect on overall investment returns.

Making trades based solely on this particular rate hike is an example of short-term thinking.

"The single greatest edge an investor can have is a long-term orientation." - Seth Klarman (Trades, Portfolio)

However, it is important to recognize that rising interest rates presents a longer-term trend.

Rather than making short-term speculative trades based on one single interest rate hike, incorporate the rising rate trend into a long-term systematic investing plan such as The 8 Rules of Dividend Investing to decrease risk and increase investment returns.

For investors looking to learn more about the interest rate hike and the future of the Fed Funds rate, the following articles might be an interesting read:

Disclosure: I am long Aflac.

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This article first appeared on GuruFocus.