What Unprecedented Low Interest Rates Mean For Investors

Summary

• We have reached levels of interest rates which are unprecedented.
• Why this is bullish for risk assets such as equities.
• Dividend stocks are hot again.
• Being an income investor is set to pay off well going forward.
• Looking for more investing ideas like this one? Get them exclusively at High Dividend Opportunities. Get started today »

Co-produced with Philip Mause

The last few months have seen aggressive action by the Federal Reserve combined with a flight to quality which have resulted in interest rates in the United States that are lower than ever before in recorded history. Treasuries are now at 0.13% for one year, 0.71% for 10 years, 1.21% for 20 years, and 1.45% for 30 years. Even in the depths of the Great Depression, rates for 10-year Treasuries were not this low. While we saw similar short-duration low rates at various times after the great depression of 2008, longer-duration rates were generally much higher and 10-year rates got no lower than the 1.5% neighborhood.

These low rates on Treasuries have impacted corporate bond rates. Alphabet (GOOG) (GOOGL) recently floated a multi-billion issue with various tranches at differing maturities – the five-year tranche paid 0.45%, the 10-year paid 1.1%, and the 40 year paid 2.25%. Apple (AAPL) has issued bonds with similar yields. The low rate environment has even affected "high yield" or junk bonds. Barron's recently listed a bond on its "high yield" list which was recently issued and which yields 3%. We are actually living in a world in which a 3% bond can be described as "high yield" without eliciting gales of laughter and scorn.

While it has become hazardous to predict where interest rates will go, it's not impossible that they may actually go lower. A number of developed economies have had extended periods of negative interest rates on government debt. While there would be serious resistance to that in the United States, it's not impossible that we will get there.

Investors often wonder what interest rates have to do with equity valuations and prices and pundits do differ on this issue. But there are some ways in which the interest rate environment can color or even determine the equity market and it's vitally important for equity investors to understand these mechanisms.

Portfolio Optimization

Many individual and institutional investors hold a mix of fixed income and equity investments. In the case of pension funds and insurance companies, they often "target" a certain annual return in order to achieve institutional goals. When interest rates decline to this extent, two things tend to happen. First, the value of the portfolio of fixed income investments held by such investors has gone up substantially as the lowering of interest rates automatically makes older fixed income holdings with higher coupons more valuable. Investors may perceive that the potential for further appreciation in seasoned fixed income holdings has become limited. With yield-to-value at low levels, it's likely that they may determine that the potential for total return in the fixed income sector is meager.

This may, in turn, lead them to cast eager eyes in the direction of equities. With interest rates this low, dividend yields on equities begin to look very attractive in comparison with bond yields. In the post-2008 Panic market, there was a pronounced tendency for the S&P 500 to trade in the vicinity of prices which would produce a 2% yield. As dividends went up, the index tended to follow. With the COVID-19 market rates at even lower rates than before, it's entirely plausible that the S&P 500 would trade at an even lower dividend yield.

Individual investors - especially retirees - seeking yield also are attracted to equities as bond yields decline. And many equities still provide solid yields. Although the S&P 500 has a relatively low yield, this is largely because many large components of the index - GOOG and Amazon (AMZN) for example - pay no dividends at all. An individual seeking holdings which yield above 4 or 5% will have trouble finding them in the fixed income universe without exposing themselves to default and/or duration risk. On the other hand, there are some solid companies whose stocks pay yields in this range.

Balance Sheet Optimization

Corporations can take advantage of ultra-low interest rates by optimizing their balance sheets. The simplest step is to pay off high interest debt with funds generated by new borrowing at low rates. Recent action by AT&T suggests that it's taking advantage of low rates in this manner.

A more complex strategy involves changing the balance between debt and equity on the balance sheet. A company can issue bonds at extremely low levels and use the funds to buy back its own stock, thereby changing the mix of debt and equity on its balance sheet. Simple math demonstrates that - as long as the after tax interest rate paid the company is less than the reciprocal of the company's price/earnings ratio - the company will actually increase its earnings per share by taking this action. For example, if a company can borrow at 1% interest, then borrowing at that rate and using the funds to buy back stock will increase the price/earnings ratio of any company whose pre-existing price/earnings ratio was less than 100 to 1.

Another strategy can be the use of funds raised with cheap debt to acquire additional cash flow through corporate acquisitions. Again, as noted above, if the company can borrow at 1% interest, then it can pay up to 100 times earnings for an acquisition and still increase its earnings after all is done. As the potential for this sinks in on investors, it's likely that the share prices of companies which are acquisition targets will trade up.

Dividend Stocks Are Hot Again

The markets have already rewarded the high-flyers technology stocks, such as AAPL, GOOG, AMZN and Facebook (FB) for their ability to borrow at low interest rates and grow – even during the most difficult times. However, many great companies have been left behind, despite also being able to borrow at historical low interest rates, and by doing so generate decent growth. Such companies are what we call value stocks. Today, the valuation gaps between growth stocks and value stocks is at its highest level ever.

Source: BMO

Based on valuations (both Price/Earnings ratios and EV/EBIDTA ratios), growth stocks are most expensive they have ever been, while value stocks the cheapest they have been for decades.

Many high yield sectors fall within the "value stock" definition, trading today at very attractive valuations. No wonder that dividend stocks are hot again. We have been witnessing over the past few weeks a strong outperformance of high-dividend stocks that have lagged the markets for many years now. Based on this recent market action, investors have been pulling away from technology stocks (QQQ)and into dividend stocks (DVY).

Data by YCharts

This is likely to be a strong trend going forward. If we look at history, when the valuation gap between growth and value was so high, value stocks outperformed growth stocks by 26% over the next three years. This is really amazing.

Need For Selectivity

Investors should exercise care in choosing equities. Some companies (including dividend-paying ones) are better positioned to take advantage of borrowing at cheap rates than others. Those that are able to borrow at much cheaper rates than they were a few years back, and which have demonstrated the ability to continue to produce relatively stable cash flows during the pandemic, are best positioned to capitalize on the current environment.

Conclusion

Watching valuations and market trends is one key to successful investing. Smart investors are currently rotating from expensive stocks to cheap ones. This is good news for income investors because many high-yielding sectors fall within this cheap stock category. If you are an income investor, your portfolio may have not provided the returns that technology stocks have over the past three years, but the future looks very different. Dividend investors are set to be greatly rewarded.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.