When it comes to investing, interest rates are always at the top of investors’ minds, and for good reason. They have a massive impact on how stocks, especially ones that pay dividends, are valued, in addition to how the broader economy behaves.
In recent years, interest rates have dominated almost every economic conversation. They were forced higher to control the surge in inflation, stayed front and centre as rising living costs collided with higher borrowing expenses, and now remain in the spotlight as investors wait for long-anticipated cuts.
The problem is that they can also be confusing for some investors. When rates rise, certain sectors stumble. When rates fall, others take off. So, in order to make sense of which dividend stocks can hold up through rate cuts, it helps to understand the basic mechanics.
How do interest rates work?
Essentially, central banks increase interest rates to pull money out of the economy, such as during periods of surging inflation. By increasing interest rates, borrowing becomes more expensive, yields on stocks and bonds rise, and stock valuations generally decline. Furthermore, companies with meaningful debt loads also face shrinking margins because their interest expenses climb.
On the flip side, when interest rates are lowered, borrowing becomes cheaper, so economic activity tends to pick up, and the discount rate used to value future cash flows drops.
That combination typically pushes stock prices higher, especially for companies that rely on steady cash flows or carry large amounts of debt. In fact, lower interest rates pushing valuations higher is one of the major reasons the market has performed so well this year.
So, the good news for investors is that most Canadian dividend stocks actually benefit when interest rates start moving lower.
With that said, though, not every industry experiences rate cuts the same way. One area that sees more of a mixed impact is the financial sector.
How is the financial sector impacted by interest rate cuts?
Although interest rate decreases help improve the valuation of all stocks because of the lower discount rate used to value future cash flows, companies in the financial sector can see mixed impacts from lower interest rates.
Banks, for example, can face pressure on net-interest margins as lending rates adjust downward faster than deposit costs. With that being said, though, lower interest rates also reduce the frequency of loans underperforming, so even bank stocks can see their operations positively impacted by falling interest rates.
Meanwhile, insurance companies can also experience slight headwinds as a result of lower interest rates since they tend to earn less on the fixed-income portfolios that support their long-term liabilities.
What are the best dividend stocks to buy now?
The majority of stocks, though, will benefit from lower interest rates, whether it’s due to valuations across the board increasing, less interest expense impacting profit margins, or more money in the economy being used to consume goods.
That’s why right now is one of the best times for investors to buy high-quality Canadian stocks, especially ones that are trading below fair value.
For example, many stocks in the real estate sector continue to trade ultra-cheaply as a result of the impact higher interest rates have had on their operations.
Killam Apartment REIT (TSX:KMP.UN), a $2 billion residential REIT, is a perfect example. Not only is the stock trading at a forward price-to-funds-from-operations (P/FFO) ratio of 13.2 times, which is considerably cheap for a residential REIT. But that’s also well below its five-year average forward P/FFO ratio of 16.1 times. Furthermore, its current forward dividend yield of 4.4% is also considerably higher than its five-year average forward yield of 3.9%.
Plus, in addition to Killam, a residential REIT that’s even cheaper is Minto REIT (TSX:MI.UN), a roughly $500 million company with properties in major cities all across Canada.
Minto is currently trading at a forward P/FFO ratio of 13.8 times, which may seem higher than Killam on the surface. However, its five-year average forward P/FFO ratio is upwards of 20 times, showing just how cheaply Minto is trading today.
So, if you’re looking for high-quality stocks trading cheaply, I’d consider these top dividend stocks soon before interest rates continue to decline.
