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Between being a doctoral student in economic statistics, a certified financial planner and an author here at Seeking Alpha, I spend a lot of time talking about investing strategy. One thing that worries me, however, is a lot of dividend investors who appear to be looking in the rear view mirror and are now almost exclusively chasing high yield stocks. REITs, MLPs and such have had an epic bull run this decade and having all, or a substantial portion of your net worth in high yielding stocks would have been a great move ten years ago; now, your being exposed to very substantial interest rate risk.

Everyone's investment needs are different. For myself, I am still two plus decades away from retirement, have amassed a decent portfolio, plan on growing my investments through dividend reinvestment and new capital and am looking for a high total return through dividend income and capital appreciation. Now, people at or near retirement who need the current income and can handle some capital depreciation can relax as there is no reason to think even high yielding stocks will have to cut their payouts anytime soon. However, for people in a similar investment boat as myself, it is time to start taking interest rate risk seriously.

Higher interest rates hurt companies in at least two major ways: debt becomes more expensive to service, cutting into earnings, and, as bond yields increase, the market values dividend yields less. This can be a potent one-two punch for high-debt, high-yield sectors like utilities, real estate and pipelines. But with bonds yielding somewhere between diddley and squat right now, any stock with a decent dividend is trading at a premium value.

I won't pretend to know the exact moment in time interest rates will bottom, or how fast they will rise afterwards; in fact, I would recommend ignoring any self-styled soothsayers who claim to know such things. In all seriousness, I could see interest rates to start a sustainable rise this month or take a full two years to hit rock bottom. In any case, with short-term rates essentially zero, interest rates and corresponding bond yields have no where to go but up and its time to start adjusting our long term investment plans.

I am going to make a few general suggestions for dividend investors to minimize interest rate in their portfolios but first, to get things warmed up, let's look at this table of correlations between stock prices by sector and ten-year U.S. bond yields:


(Click to enlarge)

Suggestion #1: Get Some Energy for Your Portfolio

As you can see from the above chart, the energy sector does very well when interest rates are low and rising. Energy also out-performs during secular bear markets. Exactly today's investing climate! There are many good choices out there but I would especially recommend Canada's Baytex Energy (BTE) and Columbia's Ecopetrol (EC). They both have income plus growth business models that should be very appealing to dividend oriented investors. Personally, I am significantly overweight energy in my portfolio.

Suggestion #2: Go for Growth

Fixed income is just so ... fixed. Stocks can offer dividend growth and capital appreciation and no interest rate will change that. Companies that can offer both those things should weather an increase in interest rates relatively well. This can be a simple change inside a sector. For example, I love tobacco companies: high profit margins, strong brand loyalty and an addictive product -- what's not to love? Instead of going with Reynolds (RAI) or Altria (MO), a long-term investor may instead choose Philip Morris (PM). Your sacrificing more than 100 bps of yield but the stronger growth profile should support the share price over the long-term.

Suggestion #3: Ditch the Debt

Everyone knows that holding bonds in a raising-rate environment is suicide but not everyone is aware that low-growth, high-yield stocks are in the same (sinking) boat -- and doubly so if they have a lot of debt on their books. I have already mentioned that real estate and pipelines will get hammered by rising rates but the chart above shows that you can add utilities and telecoms to that group.

So...it's time to start selling! You could just dump your high-yield stocks now, and risk missing the last of the upside; or, wait until there are more definitive signs of a top in these sectors and risk being burned by the first wave of selling. A more sensible approach seems to average your sales out, perhaps into rallies, over the next year or two.

Suggestion #4: Upgrade your Portfolio with some Technology

As the chart above makes obvious, technology does extremely well in both rising rate and high interest rate environments. There is an interesting discussion on why this sector is so different from others in this regard but that is beyond the scope of this article and will have to wait until I am with my fellow econo-geeks at the university.

Since consumer discretionary also does well in this environment, gadget makers like Apple (AAPL) could make sense; however, I know very little about the technology sector so I will avoid making any specific recommendations.

Conclusion

In the last year, I have spoken with many investors whose portfolios are concentrated in a few yield-heavy sectors. Hopefully, they are just a few extremists and don't represent the average investor, especially the more well-informed investor that Seeking Alpha attracts. However, just in case there are more folks like this out there, I wanted to sound a friendly warning about the hidden but very significant interest rate risk an investor is taking on by chasing high yield.

There will undoubtedly be some people who think that I am way off the mark with this article and that is perfectly fine. I would just recommend a diversified portfolio -- in that case, whether I am completely right or dead wrong, your portfolio will do just fine.

Source: Dividend Investors Need To Protect Their Portfolios From Interest Rate Risk