We expect interest rates to keep climbing in 2018. Higher rates have hurt the prices of high-yield stocks. They often raise their dividends, however, while bonds never pay more. And dividends are taxed less than interest. So buy some high-quality, dividend-paying stocks.
Interest rates are rising, of course. The yield curve on The Back Page shows that rates are substantially higher than they were a year ago. We expect interest rates to rise further in 2018. While this has hurt the share prices of companies that pay attractive dividends, they have certain factors on their side. As a result, you can buy them cheaply.
One factor sending Canadian interest rates up is higher interest rates in the US. The Federal Reserve (the American central bank) has repeatedly increased its federal funds rate. It’s expected to do so several more times both this year and next.
Inflation, not unemployment, is the worry
The US unemployment rate of 3.9 per cent is at its lowest level since December, 2000. This means that unusually-low interest rates are no longer needed.
The US Consumer Price Index rose 2.5 per cent for the 12 months ended in April. But the low unemployment rate suggests that wages will rise more quickly in the US. Especially since it’s combined with a ‘loose’ fiscal policy, following President Trump’s massive tax cuts. The way the Federal Reserve tries to restrain inflation is to raise interest rates.
Canadian interest rates generally follow US interest rates. Indeed, the Bank of Canada raised its over-night lending rate three times in 2017 and twice more so far this year. It’s expected to raise its benchmark rate again later on this year.
Higher interest rates make bonds more attractive relative to stocks. After all, why invest in risky stocks when you can earn a decent risk-free return from governments? That’s likely why some high-yielding stocks are down. This includes many utilities—such as pipelines, electricity and natural gas companies and telephone companies. Higher interest rates also adversely impact the shares of REITs (Real Estate Investment Trusts) and income trusts.
High-dividend stocks beat bonds in several ways
Even so, high-dividend stocks have several advantages over bonds. First, many high-dividend stocks raise their dividends each year. Bonds never pay more than what they promise to.
Second, outside of tax-deferred plans, dividends receive better tax treatment. Dividends benefit from the Canadian dividend tax credit. Interest, by contrast, is fully taxed at your marginal tax rate.
Third, inflation is always bad for bond prices. To the extent that firms can raise their prices and earn more, moderate inflation need not hurt stock prices.
Dividends, capital gains and a free lunch
Whenever we give this advice, we are reminded of a passage from Peter Lynch’s book Beating the Street:
“Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond. Bondholders aren’t invited to annual meetings to see the slide shows, eat hors d’oeuvres, and get their questions answered, and they don’t get bonuses when the issuers of the bonds have a good year. The most a bondholder can expect to get is his or her principal back, after its value has been shrunk by inflation.”
So continue to buy high dividend stocks—especially from companies that raise their dividends every year—such as those that we feature in our monthly Investment Planning Guide.
This is an edited version of an article that was originally published for subscribers in the June 1, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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