US Fed rate hike: How do interest rates impact dividend stocks?

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Highlights

  • The US Fed has hiked official rate by 0.75% for the second straight month.

  • The latest rate hike is the steepest since early 1980s.

  • Telecom, real estate investment trusts (REITs) and utilities are most sensitive to interest rates.

The US Federal Reserve has hiked interest rates by 0.75% for a second straight month. With this, the overnight borrowing interest rate now hovers in the range of 2.25% to 2.5%. But how does it impact the stocks, especially the dividend players?

Dividend-paying stocks have always remained in demand among investors. The importance of these stocks increases significantly during challenging times as these ensure a steady stream of income. Dividend stocks assume greater importance when the rates are low. But what happens to these stocks and their payout ratios when the central bank start to raise rates.

Which stocks are most sensitive to interest rate changes?

The stocks with highest dividend yields belong to sectors such as telecom, real estate investment trusts (REITs) and utilities. Such companies generally have high debt load.

These stocks are most sensitive to interest rates, implying their prices fall with every rise in rates and vice versa. The debt-servicing costs of the firms with higher debt load increases when interest rates rise, resulting in a negative impact on their profitability.

As already explained, interest rate changes can impact the profitability of companies, thereby constraining their dividend payout capacity. It is more evident in case of debt-laden firms. It has been witnessed several times that the mere anticipation of rate hikes in the US can have an impact on the profitability of companies all across the world. Higher interest rates in the US can make the US dollar stronger, which ultimately lowers contribution from foreign earnings, thus impacting the profits of a company.

Similarly, muted commodity prices have a negative correlation with the greenback. It can have a significant impact on the profits of commodity producers.

Impact on bond yields

An interest rate hike is usually followed by an increase in stock market volatility. In such a scenario, investors find short-term debt and certificates of deposit attractive when interest rates rise. Even the longer-term bonds look attractive as their yields rise while bond prices fall in line with climbing rates.

But investors should also be aware of the fact that while equities offer the prospect of capital appreciation along with dividends, debt offers low competition at a time when yields hit record lows.

However, not all stocks are impacted by interest rates hikes. Take for instance, banking stocks – which tend to do well even when the rates rise. It happens because their net interest margins improve, resulting in a positive impact on their profitability.


 


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