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Utilities and Consumer Staples flourished in the low rate environment over the last few years, even managing to outperform almost every other sector in 2011. Now, as rates increase, investors are stampeding out of the two sectors and looking for dividend-payers that can prosper in the new environment of higher credit costs. Look for companies with high underfunded pension obligations and low payout ratios to surprise on the upside when it comes to returning shareholder cash.

Why rates matter to dividend stocks

First, you need to understand why dividend stocks are usually poor performers when rates increase. Most dividend stocks are in industries with relatively subdued prospects for growth. This makes intuitive sense if you consider choices a company makes for its cash. It either uses cash for growth opportunities or, if there are none, returns it to shareholders.

As a result, the company pays out much of its net income as dividends. This low growth and high payout ratio limits the potential for price appreciation in the shares and makes the stock more like a bond. Investors can be fairly certain to get the share price they paid when they sell the stock but may not get much more.

Since much of the return is from the dividend, between quarters anyway, then rising rates make other investments more attractive. Why would you buy a 3% yielding stock when you can buy high-yield bonds that pay 5% or better?

Who wins with higher rates?

There is one group of stocks that could come out much stronger in a rising rate environment, those with large underfunded pension obligations. Companies estimate their future pension obligations using a discount rate, set off of prevailing interest rates, to arrive at a present value liability. A lower rate means that the present value of these liabilities is larger and the company must set aside more money to fund their plan.

As rates increase, the discount rate used in these present value calculations will also increase and the company will find themselves in a better financial position. Granted, it is simply a change to estimates and dangerously high pension obligations may eventually bankrupt the company but we are talking about short-term upside surprises not long-term core investments.

Besides high, underfunded pension obligations you will also want to look for companies with lower payout ratios and free cash flows. This increases the chance that the company will be able to boost the dividend when their financial picture improves.

KLA-Tencor (NASDAQ:KLAC) reported earnings last week but got no love from Wall Street. The $10.6 billion chipmaker reported second-quarter sales of $705 million last week, meeting expectations but not doing much for the shares. Net income rose 31% to $0.83 a share from the same quarter last year.

Payout ratio of 48% in fiscal 2013 on a 28% drop in net income, with expectations for an increase in net income to $3.80 in 2014 the payout ratio drops to just 42% and leaves plenty of room for a dividend increase. The company has repurchased an average of $257 million in shares over each of the three years, increasing total cash to shareholders. Despite the weakness in revenue, free cash flow has remained relatively consistent above $800 million a year.

The company reported pension obligations of $65 million at the end of 2013 with assets of just $12 million, making it one of the most underfunded in the S&P 500. The company uses a discount rate of just 1.3%, which is extremely low and could be raised with higher rates.

The company pays a 2.8% yield, which has increased at an annualized 21.4% over the last three years.

Exxon Mobil (NYSE:XOM) reports earnings on January 29th with expectations for a sharp 13% drop in earnings per share. Even with the drop in net income over the last twelve months and an increase in dividends paid, the payout ratio is still just 31%. The company has slowed its share repurchases but still returned $17.9 billion to shareholders through buybacks over the last year.

Capital expenditures have increased, cutting free cash flow, but should pay off with higher income in the future. Exxon Mobil uses a discount rate of 4% (down from 5% in 2011) for pension obligations. The company reported pension liabilities of $15.9 billion at the end of 2012 with a funding status of about 63%.

The company pays a 2.5% yield, which has increased at an annualized 12.6% over the last three years.

The rising rate environment, and its effect on pension liabilities, does not alone make these stocks good buys. It could lead to upside surprises in their financial health but you need to look at sales expectations and other fundamentals as well.

Source: Dividend Stocks That Win With Higher Interest Rates