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Owning dividend stocks that pay 3 to 7 per cent are more attractive if you also get some capital appreciation upside and dividend growth, one advisor says.

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The massive jump in interest rates during the past year has surprised many investors – and had some negative impacts on portfolios.

Fixed-income investments lost value, as did heavily leveraged sectors such as real estate. Dividend-paying stocks – including banks, utilities and real estate investment trusts – took a hit, as the payouts in fixed income became an attractive alternative. To make matters worse, rising interest rates mean higher costs for individuals, particularly for those holding debt such as a mortgage or line of credit.

However, rising interest rates have also presented an opportunity for advisors and clients. Specifically, there are now short-term investments with payout rates greater than longer-term fixed-income vehicles – and with more predictable returns than equities.

“We’ve been rebalancing client portfolios and taking advantage of the higher interest rate environment by adjusting both what we own in our fixed income portfolios, as well as how our equity portfolios are positioned,” says Maili Wong, senior wealth advisor and senior portfolio manager with The Wong Group at Wellington-Altus Private Wealth Inc. in Vancouver.

Ms. Wong’s clients have owned short-duration investments, such as high-interest savings account exchange-traded funds (ETFs) that now yield close to 5 per cent with full liquidity, in the fixed-income portion of their portfolios during the past year.

“Doing so allows our clients to get paid more interest while staying safe, when usually it’s one or the other,” she says.

Elaborating on the moves, Ms. Wong notes the advantages of holding high-interest-bearing short-term investments include the interest earned on a relatively low-risk investment. The drawbacks include the interest rate only being fixed for a short period of time, and the risk of not earning a high enough return over the long term to meet the client’s needs and goals.

She also notes the interest income earned on these short-term investments is fully taxable at the client’s marginal tax rate. In addition, there’s potential reinvestment risk. If the high short-term rates are temporary, at the end of their term, investors may end up having to either roll over into a lower-yielding investment or search for yield elsewhere.

These short-term investments can work well in rising interest rate environments, but not so well if rates reverse course and move in the opposite direction.

Throughout the past six months, Ms. Wong’s model accounts have also added some medium-term high-quality bond exposure.

“Adding some duration can lead to potential gains in these bonds in case we head into a recession and interest rates head lower,” she says.

Yields heading upward with higher interest rates

Meanwhile, Mary Hagerman, senior portfolio manager and investment advisor with The Mary Hagerman Group at Raymond James Ltd. in Montreal, says her best move of 2022 in the fixed-income portion of her portfolios was moving to short-term cash equivalent investments early in the year even before the Russian invasion of Ukraine.

Ms. Hagerman uses passive fixed-income ETFs primarily in her portfolios and she says it was clear to her they would be losing money as interest rates were destined to rise.

“These products were all paying less than 1 per cent at the time, and I was prepared to take a very low return when I made the move in order to not lose money, and it paid off,” she says.

The specific funds included Purpose High Interest Savings Fund PSA-T, CI High Interest Savings ETF CSAV-T and Horizons Cash Maximizer ETF HSAV-T. She notes all of these products have had yields adjusted upward with the increase in interest rates, so holding onto them has paid off accordingly.

In addition, Ms. Hagerman says that in mid-2022, with the confirmation that fighting inflation with higher interest rates was the focus of the U.S. Federal Reserve Board, she started adding floating-rate products such as PIMCO Income Strategy Fund PFL-N and iShares Floating Rate Index ETF XFR-T to the fixed-income portion of client accounts.

Ms. Hagerman feels we’re getting very close to the end of the central banks’ interest rate hikes. As a result, she’s looking at extending the bond duration of her recommended fixed-income investments to include long maturities with products such as Vanguard Canadian Aggregate Bond Index ETF VAB-T and Horizons Canadian Select Universe Bond ETF HBB-T, which has the added benefit of being tax efficient for non-registered portfolios.

She has also increased the fixed-income weighting in her portfolios, considering the attractive yield on these products and the low probability of any capital losses.

‘Both are a win-win’

Some advisors feel you basically can’t go wrong when it comes to choosing between higher payout short-term investments and dividend stocks.

“Both are ‘win-win’ here,” says Greg Newman, senior wealth advisor and portfolio manager with The Newman Group at Scotia Wealth Management in Toronto.

“Earning a close to 5 per cent guaranteed return with a high-interest savings product is great with Canadian inflation at 3.4 per cent,” he says.

He notes that unlike dividend payments, the interest is fully taxable but in tax-sheltered accounts, the payout is very attractive. He says owning dividend stocks that pay 3 to 7 per cent are more attractive if you also get some capital appreciation upside and dividend growth. He notes the tax rate is also more favourable.

Mr. Newman says he’s currently “holding steady” in terms of overall asset allocation.

“We’re not overweight equities and we are not underweight,” he says. “Each asset class is working pretty hard and giving investors nice results.”

More specifically, he favours oversold dividend stocks such as insurance companies, utilities and in energy infrastructure. He also says commodity stocks that are levered to the decarbonization and environmental, social and governance theme “also make a lot of sense.”

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