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If you have been reading the financial press and/or watching CNBC lately, you no doubt have seen or heard many stories about dividend stocks heading for a sell-off. It appears all the "experts" have determined that the Federal Reserve will soon end their stimulus program and interest rates will shoot up. Their thesis is that if interest rates go higher, investors will not want dividend paying stocks. After reading a number of these articles, I thought I would research how rising interest rates have affected stock prices in the past.

1 - Our Favorite Dividend Growth Stocks Perform Just Fine!

The last year I could find where interest rates rose a significant amount was 1999. For those of you who do not remember, 1999 was the last year of a very bullish decade for stocks and the culmination of the "internet bubble."

When the trading year began, the 30-year Treasury was at 5.15% and the 10-year was at 4.57%. When the year ended, the 30-year had risen to 6.48% and the 10-year was at 6.45%. That is a significant move in interest rates over one year, yet our favorite dividend growth stocks performed just fine. Below is a chart that shows just how well they did.

CompanyPrice 01/04/99Price 12/31/99Gain
Procter & Gamble (NYSE:PG)90.00109.5621.7%
Johnson & Johnson (NYSE:JNJ)82.6993.2513.97%
Exxon (NYSE:XOM)72.6280.5610.9%
McDonald's (NYSE:MCD)38.47 (split adjusted)40.314.7%

As you can see, rising interest rates were not the death knell for dividend paying stocks. Dividend stocks performed just fine and have performed well in previous rising interest rate environments. Interest rates ticking up a percent does not stop a person from buying shampoo, eating at McDonald's or buying a prescription medication.

Rising or falling interest rates are not the determining factor for the majority of stocks' prices, rising or falling earnings determines stock prices. As shown above, Procter & Gamble and Johnson & Johnson shareholders had an outstanding year in 1999. Those shareholders had a good year because the company they owned stock in had a good year. JNJ reported record results for 1999, earning $4.17 billion on revenues of $27.47 billion. P&G also had a good year, with Core Basic Net Earnings rising 11% and sales rising 3%.

However, Coca-Cola (NYSE:KO) another favorite dividend growth stock, saw its stock price fall from $67.19 to $58.25. Was this because interest rates rose? No it wasn't. It was because Coke's earnings fell for the year and Coke's operating income fell 25%.

If the company you own stock in has a good year and earnings grow, chances are the stock will go up.

Utilities Will Suffer

Utilities, on the other hand, did see significant stock price depreciation. Almost every major utility I researched showed a fall in price. A representative sample is below.

CompanyPrice 01/04/99Price 12/31/99% Loss
Southern (NYSE:SO)27.5123.1915%
Duke (NYSE:DUK)64.5650.1322%
Con Ed (NYSE:ED)52.7534.5034%

It is historically well-documented that utility stock prices suffer during periods of rising interest rates. In fact, a number of academic studies have attempted to find the cause for the utility-interest rate relationship.

In a Financial Review article from 1998, the authors listed three possible reasons for falling utility stock prices during periods of rising interest rates. The three reasons are shown below.

1 - Interest rate sensitivity is the result of "regulatory lag" effect. The authors contend that regulated utilities will see a higher cost for borrowing when interest rates rise, but will not be able to recoup this higher cost for some period of time, as regulators are typically slow to grant rate increases.

2 - Utilities typically carry higher debt levels than companies from others sectors and thus will see a higher cost for the debt they carry.

3 - Utilities are purchased mainly by investors valuing the traditionally stable fixed-income nature of utility stocks. This pervasive investing strategy causes utility equity price movements to mirror the price movements of more traditional yield instruments.

I don't know if any of those are the reason utility prices fall when interest rates rise, but my feeling is that a little of all of those reasons play a role. However, I believe the main reason is that investors are keenly aware of market history, and market history has shown utility prices fall when rates rise. Therefore, owners of utility stocks, especially fund managers, sell them when they see rates rising.

The REIT Bull Market Will Subside

In the 1999 rising rate environment, REITs did not flourish, but they were not slaughtered either. Below is a chart that shows how some of the better-known REIT names did in 1999.

Company

Price 01/04/99

Price 12/31/1999% Loss
Vornado (NYSE:VNO)34.2532.505%
Realty Income (NYSE:O)21.9820.287%
Weingarten Realty (NYSE:WRI)44.9438.9413%

REITs, like utilities, have a history of performing poorly when interest rates rise. In the past few weeks, just the talk of Federal Reserve "tapering" resulted in many investors running for the door and REITs dropping in price. Realty Income, perhaps the most widely held REIT, fell from $55.03 on May 17th to $44.83 on Friday, June 7th, for a loss of 18% in 3 weeks.

Despite the recent losses from just the hint of raising rates, many REIT managers believe this time may be different. They mention that many REITs have inflation adjustment clauses in their rent agreements and should be able to recoup some of the higher costs of borrowing. They also state that rates are at historically low levels, and the economy isn't strong enough to withstand a spike in interest rates. A small increase in rates from the current very low levels shouldn't affect well-managed REITs.

That may be true, but REITs have had a nice run, up approximately 20% in 2012 and 7.5% in 2011. If just the hint of "tapering" could start a sell-off in REITs like we just saw, I have to believe actual rising rates would be detrimental to REIT prices.

Master Limited Partnerships

I did check on the performance of MLPs in 1999, but do not feel I have enough evidence to draw a conclusion. Enterprise Products (NYSE:EPD) had just gone public in 1998 and Kinder Morgan Partners (NYSE:KMP) was still a relatively small company. For the record, both companies saw stock price gains in 1999.

Unlike REITs that were hit hard in the last three weeks, MLPs saw much smaller price declines. EPD was down 2% in the May 17th to June 7th time period, and KMP lost 5%.

With the limited evidence I have, I do not believe MLPs will be hurt by rising interest rates as much as utilities or REITs.

Will This Time Be Different?

In 1999, 30-Year Treasury rates jumped approximately 1.3% from 5.15% to 6.48%. The 30-Year Treasury rate is now approximately 3.3% and the chances it jumps to 4.6% any time soon are probably slim. The daily news flash from various Federal Reserve Presidents reveals that there is no consensus on how to proceed with the quantitative easing program. However, it does appear to me that the tide is swinging to ending or at least reducing the program.

When it becomes official that the Federal Reserve is adjusting their easing program, interest rates will go up, that I am sure of. When rates rise, I am also sure we will see selling in utilities and REITs; they have sold them in the past and they will sell them again. I believe the key question is, how far will rates move? Will they tick up a half percent and then stay there? If that is the case, the selling may be short lived. If the rate move is a steady slow move up, I think the selling could last for some time.

Could I be wrong? You bet I could. That is what makes investing difficult, you have to try and see the future and that is very difficult.

So What Should A Dividend Growth Investor Do?

There are many different types of dividend growth investors. Some dividend growth investors are only concerned about the dividend and the income, while others are looking for some capital appreciation along with their dividend. Some dividend investors have a minimum yield they need to see before buying a stock, and others are more concerned about the growth of the dividend.

With all those variables, I would not think of telling an investor what he/she should do. However, I do believe an investor needs to be aware, that chances are, utility and REIT stock prices will fall if interest rates rise. Each individual investor will have to determine what, if any, action they should take. If you are only concerned about the income, you probably need to do nothing. If you need the capital gain with income, you may want to consider exiting, or reducing your utility and/or REIT holdings. Or, if you believe the interest rate rise will be minimal or short lived, you may want to buy more in hopes the price drop is temporary. If you are like me and have been waiting for a pull-back in utilities and REITs to add one or both to your portfolio, a pullback is the opportunity to add a utility or REIT at better prices.

Changes in market conditions always present opportunities -- and opportunity to buy and/or an opportunity to sell and lock in gains. A change in market conditions is coming. Whether it is next week or four months from now, the Federal Reserve will eventually end their quantitative easing. When that happens, market conditions will change; be prepared and take the action that works best for you.

Source: Dividend Growth Winners And Losers When Rates Rise