Dividend Investors: So What if Interest Rates Rise?

The average yields for short-term, medium-term, long-term, and very long-term Government of Canada bonds are ~1.2%, ~1.4%, ~1.7%, and ~2.2%, respectively.

Some investors are worried that if interest rates continue to rise, income investors will exit their stock positions, which are viewed as riskier than government bonds.

Moreover, higher interest rates would lead to increased borrowing costs, which slow down the growth of companies.

However, interest rates are unlikely to rise significantly in a short time. Let’s say they increase by 0.25% every three months. That only equates to an interest rate hike of ~1% in a year.

Dividends can grow much faster than interest rates

You shouldn’t worry about interest rate increases at all if you hold dividend stocks that offer higher yields and, more importantly, higher growth.

Algonquin Power & Utilities Corp. (TSX:AQN)(NYSE:AQN) is an excellent example. The utility offers a decent yield of ~4.6%, and it aims to grow its dividend by 10% per year through 2021.

time is money compounding

Algonquin’s largely rate-regulated utilities and power assets with long-term agreements generate stable earnings growth to support its targeted dividend growth. From this year through 2021, the company is investing ~$6.3 billion across its power and utility businesses, which should secure growth through 2021.

Algonquin has most of its operations in the U.S. So, it offers a U.S. dollar-denominated dividend that Canadian investors can opt to receive in the Canadian or U.S. currency. As such, a stronger U.S. dollar means a higher current income for Canadian shareholders.

What about Algonquin’s debt?

Utilities are capital-intensive businesses. Algonquin has ~$4.75 billion of long-term debt compared to ~$10.88 billion of total assets. Algonquin’s debt-to-EBITDA ratio of about 5.3 times is lower than its bigger peers.

In the first quarter, Algonquin’s interest expense was $64.5 million, but the company had more than enough earnings to cover the interests, and its recent interest coverage ratio was ~1.6.

Additionally, the majority of Algonquin’s outstanding debt is subject to a fixed interest rate, so rising interest rates will have little effect on the utility’s interest expense.

Investor takeaway

Generally speaking, higher interest rates will reduce the incentive to hold dividend stocks with little growth and increase the borrowing costs of companies.

If you hold a group of quality dividend-growth stocks, which are growing at a faster pace than future interest rate hikes and have little exposure to variable interest rates, your portfolio should be fine.

Besides, there are dividend-growth stocks like Algonquin which still offer at least double the yield of what the bonds offer. So, these stocks are still the way to go for long-term returns.

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Fool contributor Kay Ng owns shares of ALGONQUIN POWER AND UTILITIES CORP.

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