Skip to main content

Getty Images/iStockphoto

With interest rates expected to plumb record lows for even longer, Canadians now face the difficult task of figuring out which sectors still have the potential to attract investor money.

As commodities crashed over the past four years, investors piled money into industries that paid high dividend yields, such as real estate trusts, banks and telecommunications firms, because their returns were so appetizing compared to risk-free government debt.

Over the past decade, dividend yields on Canadian banks averaged 135 basis points, or 1.35 percentage points, more than 10-year government bonds. Today they pay 320 basis points more than 10-year Canadian debt. During the same time period, Canadian pipelines and utility companies have averaged dividend yields of 139 basis points above benchmark bonds; today the spread over 10-year government debt is 319 basis points.

Because dividend-paying equities have performed well, there are worries that some of these stocks have hit their limits. Should rates or government bond yields suddenly move, analysts at CIBC World Markets argue that select stock sectors will fare better than others.

"We believe that the market is increasingly likely to differentiate among the various yield sectors," they wrote. If rates move in a pronounced fashion, one way or the other, "we believe that the sectors will begin to diverge meaningfully."

The hard part is deciphering precisely which groups of stocks will do what. To help, CIBC did some digging to make predictions.

"It is apparent to us that if rates fall further, telecommunications companies, real estate investment trusts and pipelines and utilities will all benefit," the analysts wrote. "However, we would expect a completely opposite move from the banks and life insurance companies."

The call on the telecom sector is arguably the hardest to defend because the industry's stock valuations continue to set record highs relative to earnings expectations, despite operating in a market being disrupted by the likes of Netflix. Yet the sector's earnings have mostly showed calm amid the storm.

"The relative stability of cable/telecom growth in what can be an otherwise volatile index has worked to keep telecom valuations moving in line with the market, with the added attractiveness of 3.9-per-cent dividend yields in a low-yield world working to further prop up sector valuations," the CIBC analysts noted.

Pipelines and utilities benefit from a similar narrative. They carry high credit ratings and are often treated as bond proxies by many investors because their cash flows are so stable. These characteristics make their average 4.2-per-cent yields look rather comforting relative to corporate bonds – especially with energy infrastructure investments at record levels, which should eventually boost their revenues.

For REITs, the thesis is a little more complex. As real estate owners and operators, these companies have big exposure to the underlying Canadian economy, and growth woes in cities such as Calgary hurt the outlook for office building and apartment vacancies.

However, REITS were recently handed their own sector classification as a TSX sub-index this year, which makes it easier for investors to bet specifically on them and their hefty yields. CIBC expects that to draw more money over time. Lower interest rates also directly benefit the sector because they lower mortgage costs.

Banks and life insurance companies are in a different boat. At their very core, banks make money by borrowing money cheaply and then lending it out at a higher rate. In the current market, this spread – known as the net interest margin – is under incessant pressure, hampering the ability to make sizable profits off their massive loan portfolios.

Life insurers, meanwhile, have very long-term liabilities that must be pre-funded – much of it through fixed-income securities. With 30-year debt paying so little, it is tough to make a decent return on their insurance policies.

The caveat, though, is that both sectors have been diversifying their earnings of late – particularly by adding exposure to asset management. By doing so, they are growing more insulated from the negative impacts of lower rates.