How low do you think interest rates are heading? With the inflation rate sitting at a comfortable 2.5%, some are expecting the focus going forward to be squarely on slowing economic conditions. This could prompt more aggressive rate cuts from the Bank of Canada than most are expecting. What does this mean for interest rate-sensitive stocks?
Let’s explore.
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Interest rate-sensitive stocks
Interest rate-sensitive stocks like utility stocks are a good bet when interest rates are falling. This is because utility companies are typically heavily indebted. Rising interest rates increase interest expense and the cost of capital, which reduces profitability. On the flip side, falling interest rates reduce their cost of capital and, therefore, increase their profitability. This is where we are today.
Moreover, utility companies typically pay out dividends. When interest rates are rising and/or high, investors have more options for income. This is because, in this scenario, the interest rate offered on bonds begins to compete favourably with dividend yields.
Last year, I invested in a Guaranteed Investment Certificate (GIC) that was yielding 5%. There’s zero risk with this investment, so at 5%, I jumped on it. It gave me less incentive to take on the added risk of investing in a dividend-paying stock.
It follows that when interest rates are low/falling, dividend-paying stocks become more attractive. This is because dividend yields begin to exceed the rates that bonds are offering, making them worth the added risk. This increased demand for these stocks pushes the stocks higher.
Fortis rallies on falling rates
The Bank of Canada has already reduced its interest rate to 4.25%. Recall that the rate was at 5% not too long ago. Already, Fortis’s (TSX:FTC) stock price is up 9% year to date and 18% in the last year. If the Bank continues to reduce rates, I expect Fortis to continue its climb higher.
Fortis is a $30 billion North American utility company with $11.5 billion in annual revenue. It’s currently yielding an attractive 3.8%, with a 51-year track record of dividend increases. Looking ahead, Fortis is forecasting a 4-6% annual dividend-growth rate to the year 2029.
Just today, the company released its five-year capital plan, which includes $26 billion in capital expenditures ($1 billion higher than the previous plan). Despite this, the company announced a 4.2% dividend increase and extended its guidance for 4-6% annual dividend increases to 2029.
Bank of Canada rate cuts to drive value for Fortis
As discussed in the earlier section of this article, Fortis and the utility sector are among the most impacted by rising interest rates. With rates coming down, investors can now focus on Fortis, the company.
It has a diverse geographic footprint and asset mix. It has a revenue profile that’s regulated. In turn, this translates into steady, secure, and predictable revenue — qualities that are highly valuable. Also, it’s in a defensive industry — one that will not suffer from the potential economic troubles coming our way. Finally, Fortis is benefitting from strong secular trends, one of which is the growing population, which is driving energy demand higher.
The bottom line
The Bank of Canada’s moves on lowering interest rates has many beneficiaries. The utility sector is very sensitive to interest rates and will continue to benefit from falling rates. Fortis is my favourite utility stock to own, with a bright future as it continues to reap the rewards for years to come.
