Gauging pain of rising interest rates on dividend stocks

Dividend stocks have shrugged off every piece of bad news thrown at them – the European debt crisis, China's slowdown, the sluggish U.S. economy.

But their biggest test is yet to come: rising interest rates.

With the global economic outlook improving, the rock-bottom yields on government bonds have been creeping higher. Since Jan. 1, the yield on the 10-year U.S. Treasury has climbed more than a quarter-point to 2.15 per cent, and Canadian yields have also moved off their lows.

While the increases have been muted so far, a sustained rise in yields would pose a threat to dividend stocks, some analysts warn. That's because higher interest rates make bond yields more competitive with stocks and also push up borrowing costs for companies.

George Vasic, chief economist and equity strategist at UBS Securities Canada in Toronto, studied the relationship between government bond yields and stocks over the past 20 years and found some surprising patterns.

When the 10-year Canada yield was less than 4 per cent, there was – somewhat counterintuitively – a weak positive correlation between changes in interest rates and the S&P/TSX composite index.

"Stocks and bond yields tend to move together when yields are low," Mr. Vasic said in a note. That's probably because, when yields are depressed, any increase is seen as a sign that the economy is improving, which also benefits stocks.

However, when yields are above 4 per cent, the relationship reverses, and further increases in yields have a moderate negative correlation with the stock market.

The bad news for investors is that certain stocks – including some classic dividend-paying sectors – feel the pain of rising rates sooner than others.

Telecoms, utilities and consumer staples, for example, had modest negative correlations to interest rates even when yields were less than 4 per cent. Energy, insurance and technology stocks, on the other hand, had better relative performance when rates were low but rising.

Given those historical patterns, Mr. Vasic said investors who believe rates will rise should consider underweighting some of the more vulnerable sectors and increasing their exposure to sectors that have performed relatively well when rates rise. UBS forecasts that the 10-year Canada yield will rise to 2.5 per cent by the end of 2012 and 3 per cent by the end of 2013, compared with about 2.1 per cent currently.

Dividend fund managers say there's no reason to panic.

"We're expecting rates will go up a little, not a lot," said Renato Anzovino, portfolio manager with C.F.G. Heward Investment Management in Montreal. Stocks with high yields and low growth prospects would be most vulnerable if rates rise, he said, but those with growing earnings and dividends should hold up well.

"I'm not concerned that rates are going to back up a lot and make all dividend stocks come down a lot," he said.

Tony Demarin, president of BCV Asset Management in Winnipeg, agrees that rising rates don't pose a huge threat because borrowing costs are at such low levels. Still, he said traditional interest-sensitive sectors, such as utilities and real estate investment trusts, could struggle if rates rise.

"The only area that is going to benefit, I believe, is the life insurance sector," he said. Life companies have been hammered by low interest rates, which depress the projected returns on their bond portfolios.

"Bond yields are likely going to rise a bit, but I'm not sure we're going to get dramatically rising interest rates," he said. "We're not changing our approach."

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Sectors' relative performance correlation to 10-year bond yields

Source: UBS