The Canadian economy is at a pivot point as the Bank of Canada maintains interest rates at a decade-high of 5%. Investors are relieved that no more hikes are expected. Once this interest rate seeps into the economy, mortgage holders will start feeling the pressure of a prolonged 5% rate. Economists expect this rate to continue throughout the first half of 2024, with a mild 0.25%–0.5% rate cut in the second half. The challenge is to sustain your portfolio returns in the higher interest rate environment.
The challenges of higher interest rates
High-interest rates make companies with higher debt riskier as a significant part of their profit goes into interest expense. During the rate hike period, many mid-cap companies restructured their operations, slashed dividends, and posted losses. Sectors sensitive to interest rates (banks, real estate, automotive) saw bearish momentum in the last two years.
Companies that sustained their dividends throughout the rate hike and maintained manageable payout ratios are worth buying into. BCE (TSX:BCE) is one such stock that has slipped almost 25% since the rate hike began in April 2022. Despite rising interest rates, BCE increased its dividend per share by 6% at the end of 2022. The company posted negative free cash flow (FCF) in the first half of 2023 due to higher interest rates and capital expenditures but maintained 2-10% FCF growth in its 2023 outlook.
The telecom’s revenue and operating income have been growing as 5G adoption continues. BCE can withstand high interest rates and sustain dividends per share even in a recession, as it has in the past. The company has been paying dividends for over four decades without a dividend cut. In the worst-case scenario, the company paused its dividend growth till the economic environment improved.
The stock price dip has elevated its dividend yield to 7%, creating an opportunity to lock in this yield for decades as 5G opens new earnings avenues.
The opportunities for higher interest rates
One segment that benefitted from higher interest rates was the interest earners like banks and non-banking lenders. Their interest income increased. While a small rate hike is healthy, an aggressive rate hike slows loan turnover and increases credit risk. While lenders increased their loan portfolio, one company reduced its debt.
Business jet maker Bombardier (TSX:BBD.B) continued its rally throughout the high-interest rate cycle. It continued to reduce its debt by repaying those maturing in the next 24 months, giving itself financial flexibility to invest in business. Between 2020 and 2022, Bombardier reduced its debt by 45%, decreasing its interest expense and increasing profitability. The lower debt also eased its obligation to hold large cash reserves.
Bombardier has a strong order book of US$14.7 billion. It is on track to complete its 2023 deliveries of 138 aircraft, with 56 aircraft deliveries due in the fourth quarter. Strong quarterly results and a healthy balance sheet could be reflected in its stock price, which fell by 33% from its March peak.
Investor takeaway
When interest rates rise, investment shifts from stocks to bonds. But Canada is currently at its interest rate peak. If the economy can absorb this interest rate and still grow, the central bank won’t opt for any aggressive rate cuts. It is time to adjust to a new normal of a 5% interest rate.
The above stocks thrived in a high interest-rate environment and can continue to do so. And if the central bank goes for an aggressive rate cut of 1% next year, the above two stocks could plunge. This is because a majority of investors won’t have money to invest. If you have set aside money, you could add more of these stocks to your portfolio at the dip. These stocks have the liquidity to sustain revenue declines in a weak economy and secular demand to boost revenue in a growing economy.
