Interest rate hikes are driving up bond yields and putting pressure on stock prices. Investors who have watched their portfolios take a hit in recent months are wondering how they can blunt the impact or position holdings to benefit from a rebound.
Why are interest rates so high?
The Bank of Canada and the United States Federal Reserve are trying to get inflation back down to their 2% target. Inflation in Canada in August came in at 4%, so there is still work to be done. Central banks raise interest rates to cool down the economy. Higher borrowing costs typically force businesses and consumers to reduce expenditures. As the economy slows down, there should be fewer job openings or even an increase in unemployment, which tends to reduce demand for higher wages.
The central banks will keep rates elevated until they see clear evidence that inflation is headed back to the 2% target. The risk is that they will push rates too high for too long and cause a deep economic contraction rather than a mild recession.
Interest rate impact on stock prices
Banks, utilities, energy infrastructure firms, and communications companies are all out of favour with investors right now.
In the case of the banks, there is concern that loan defaults will surge if interest rates stay high for too long.
Pipeline and communications companies tend to use considerable debt to finance their capital projects. Higher borrowing costs can put a dent in profits and reduce the cash that is available for distributions to shareholders.
At the same time, investors can now get attractive returns from interest-paying alternatives, such as Guaranteed Investment Certificates (GICs). The higher returns from no-risk investments can have a negative impact on the share prices of banks, telecoms, and pipeline companies that are traditionally popular with income investors.
How to invest to deal with high interest rates
GIC rates from Canada Deposit Insurance Corporation (CDIC) members are now available in the 5-6% range depending on the term and the financial institution. This is attractive in a volatile market, so it would make sense for investors to consider increasing the allocation to GICs while rates are high.
Dividend stocks carry risk, as investors have witnessed in the past year. However, the steep decline in many top TSX dividend-growth stocks is now looking overdone, and investors can get yields that are above GIC rates with a shot at some attractive capital gains once the rate hikes end.
At some point, the Bank of Canada and the U.S. Federal Reserve will need to start cutting rates to avoid pushing the economy into a deep recession. Once that occurs, there is a good chance that top dividend stocks will rebound.
It is a contrarian strategy, but buying stocks with good track records of dividend growth while they are down could deliver big total returns for patient investors. For example, TC Energy, Telus, and Enbridge have all increased their dividends annually for more than two decades and currently provide dividend yields of 6.7%, 8.2%, and 8.3%, respectively.
These companies have solid revenue streams that should continue to expand in the coming years to support ongoing dividend growth.
The bottom line
Investors can take advantage of the high GIC rates to get decent returns and reduce risk in their portfolios while interest rates are rising. Buy-and-hold investors who can ride out some turbulence might also consider adding oversold dividend-growth stocks in this environment to secure very attractive dividend yields and wait for a rebound.
