The Relationship Between Rate Hikes and Dividends

Includes: DIA, QQQ, RUSMF, SPY
by: Market Blog

By David Berman

When the U.S. Federal Reserve last week raised the discount rate it charges on emergency loans to banks, many observers dismissed the wider implications. Without a more meaningful improvement in the U.S. economy or a surge in inflation, these observers argued, the Fed is unlikely to raise its more influential federal funds rate any time soon.

However, the Fed’s move nonetheless gave urgency to the debate over when a fed funds rate hike will arrive and what it will mean for stocks that are sensitive to changing interest rates – especially dividend yielding stocks.

Randy Cousins, an analyst at BMO Nesbitt Burns, gives us one of the clearer examples in his recent update on Russel Metals Inc. (OTCPK:RUSMF), a North American steel distributor based in Mississauga, Ont.

After Russel reported a loss in its fourth quarter results, missing the consensus expectation among analysts, Mr. Cousins noted his disappointment with the lack of positive earnings momentum and cut his expectations for 2010 full-year earnings.

But given that investors have been turning to this stock for its hefty dividend yield, he also highlighted what could be the stock’s bigger challenge: Staying attractive as interest rates rise and make yields look less tantalizing next to fixed income investments, like bonds.

“To the extent that Russel has become a yield play, then rising interest rates as the economy gathers momentum could limit the upside in the stock,” he said in a note. He maintained a “market perform” recommendation on Russel, with a 12-month target price of $18, unchanged since last August.

With the stock trading at about $19 and paying a quarterly dividend of 25 cents, the yield is about 5.3% – beating just about every other dividend paying stock on the S&P/TSX composite index, including all of the Big Banks.

At Russel’s low point in March – when stock market indexes around the world had hit rock bottom following a steep selloff and central banks had slashed their key interest rates in a unified attempt to hold off economic calamity – the stock’s yield was close to 11%.

Around this time, though, investors were growing increasingly nervous about dividend-yielding stocks because of the number of high-profile dividend cuts, mostly by U.S. companies scrambling to shore up their cash holdings. From former blue-chip financials to General Electric Co. (NYSE:GE) to Pfizer Inc. (NYSE:PFE), once-solid looking dividends suddenly looked anything but a sure thing.

This means that rising interest rates this time around could be a confusing time for investors. When the Fed does raise its key rate, it will certainly coincide with stronger economic activity and an improving employment picture – which is going to be good news for corporate profitability. Dividends could move higher again after one of the most dismal periods for dividends in the post-war era.

As well, dividend-loving investors can always turn to the previous era when interest rates were on the rise, between June 2004 and June 2006. Back then, the Fed raised its key rate from 1% to 5.25%, but dividend-yielding stocks fared just fine.

The S&P 500 Aristrocrats index (a list of the most consistent payers on the S&P 500) gained a total of 19.3% after dividends are factored in, beating the S&P 500 by near 4 percentage points.