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Many market observers are anticipating the Fed to accelerate the pace of interest-rate hikes in 2018. We’re making a number of changes to the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio as we consider what a higher interest-rate environment might look like. We’re also cognizant of the impact that higher interest rates may have on the High Yield Dividend Newsletter and its simulated portfolio, the first edition to be released January 1, 2018.

By Kris Rosemann

The stock market has many scratching their heads, and frankly we are, too. The rapid rise in interest rates (TLT, TBT) during the past few months has been a sight to see, and while most conversations have centered on the possibility, or rather the probability, of an inverted yield curve (where long rates are lower than short rates), we maintain our view that rising interest rates of any variety can do considerable damage to an unhedged dividend-paying portfolio. We’ve covered the interest-rate sensitivity of equities in the utilities (XLU) and real estate investment trust (VNQ) arenas at great length in the past, and with the Fed looking poised to deliver three or four interest rate hikes in 2018 (maybe more, maybe less?), we think now is as prudent a time as ever to revisit the impact that the recent upward trajectory in interest rates could have on a number of ideas within the Best Ideas Newsletter and Dividend Growth Newsletter portfolio.

As it relates to equity-oriented demand for income/yield (or those buyers focusing on the yield of an equity instrument), we would expect the prices of high-yielding equities in the utility and REIT spaces to generally face pressure as incremental fixed income issuances start to sport incrementally higher yields thanks to rising interest rates. (We’ll talk how we’re going to try to capture this theme later in this note.) According to Charlie Bilello, Director of Research at Pension Partners, the 1-year, 2-year, and 5-year US Treasury yields recently hit relative peaks. As of December 21, the 1-year and 2-year yields hit their highest mark since September 2008, and the 5-year hit its highest point since April 2011. The 10-year US Treasury yield is on the rise as well, pushing the 2.5% mark as of this writing. The market has been dealing with gyrating interest rates for years, but whether 2017 will mark the inflection point is a key question. Since 1980, the federal funds rate has fallen from nearly 20% in the 1980s to practically zero today, fueling a multi-decade bull market. Is this trend coming to an end, and what about bonds?

Bond prices generally move opposite bond yields and interest rates. Over the past few decades bond prices have climbed while bond yields have fallen to historic lows—but bond prices don’t always go up.

While not the only factor to affect bond prices, U.S. interest rates have possibly the greatest influence. And in the current low-rate environment, bond investors should be wary of interest rate risk. An increase in rates could trigger potentially significant losses in unprepared bond portfolios (Source: ProShares, “Hedging Bond Risk With Inverse ETFs).

What’s more, earlier this month, an important event for income-focused investors occurred, too: the yield on the 2-Year US Treasury surpassed the dividend yield of the S&P 500. Though largely overlooked by a lethargic and sleepy stock market, this development is an important turning point, in our view, as the risk-free 2-year US Treasury note now offers a greater yield than the average of 500 of the largest companies, collectively. Here’s why this development is important: the Treasury note is “risk-free” and higher yielding, while the other is “risky” and exposed to considerable operating/economic influences (and lower yielding). Though it may take a bit longer for riskless yields to overcome those offered in the REIT and utility groups--the Utilities Select SPDR ETF and Vanguard REIT ETF currently yield ~3.3% and ~4.3%, respectively, compared to ~1.9% for the 2- year US Treasury--the market seems to already be pricing in rising rates ever so slowly.

Given the success of tax reform and the corresponding considerable uncertainty how the US government will be able to handle the reduced tax revenue (and such large corporate tax cuts), we expect risk-free yields to continue climbing, and as a result of this view, we’re going to make a couple modest tweaks to the Dividend Growth Newsletter portfolio and Best Ideas Newsletter portfolio. We are ridding the Dividend Growth Newsletter portfolio of the Vanguard REIT ETF and PPL Corp (PPL) and the Best Ideas Newsletter of the Utilities Select SPDR ETF. The two ETFs have faced considerable selling pressure as the market seems to already be pricing in a slowly-approaching “risk-reward” imbalance. As you are aware, stocks and bonds are competitors for the capital of income-minded investors, and as risk-free yields continue to march higher and as investors seek rebalancing in favor of better risk-adjusted yields, Treasury bills and notes may become incrementally more attractive than an overheated stock market…to some.

As it relates to Dividend Growth Newsletter portfolio idea PPL, as a high-yielding utility, it too, has faced pressure related to rising risk-free yields, but an added layer of risk is present in shares as well. The company generates nearly 60% of earnings from the UK (EWU), a country undergoing massive political reform in the form of its pending exit from the European Union (VGK). UK Prime Minister Theresa May recently announced a price cap on electricity and gas bills in the country in an effort to combat “rip-off energy prices once and for all.” The bill, which is currently in the draft phase, is temporary and set to expire in 2020, but energy market regulator Ofgem could push for extension through 2023. We don’t like the tone of the higher-ups at all, and given PPL’s exposure there, we’re being ultra-cautious.

Said differently, such a push may pressure rate allowances at PPL, as its utility businesses are 100% regulated, meaning the rates it is allowed to charge for energy delivery to customers is entirely at the hands of regulators. We must note that most utilities, as a result of bloated balance sheets and the capital-intensive nature of the business, register Dividend Cushion ratios that are far from desirable. However, set rate allowances from regulators typically provide ample and predictable cash flows that are sufficient in covering capital returns to shareholders. In the case of PPL, however, potential downward pressure on its rate allowances adds a degree of risk that may not be worth sticking around for, in our opinion, especially in the midst of a headwind of rising interest rates.

Whether we like it or not, rising interest rates may have a number of implications on dividend-paying equities. The removal of the two ideas in the Dividend Growth Newsletter portfolio leaves an opening for a couple new ideas, however. We’re going to add a 5% weighting of the iShares International Select Dividend ETF (IDV) to the Dividend Growth Newsletter portfolio. With PPL’s removal, we have ridded the Dividend Growth Newsletter portfolio of some modest international exposure, so we think it makes sense to rectify that immediately. The iShares International Select Dividend ETF has a few exciting weightings at the top, too, including AstraZeneca (AZN), Royal Dutch Shell (RDS.A, RDS.B) and Total (TOT), companies we may shy away from direct exposure, but within a diversified ETF, they become much more palatable. The ETF’s 12-month trailing yield is just shy of 4%.

Here’s an idea that may “play” directly into our thoughts regarding rising interest rates, and it sports a very nice yield, too. We’re drawn to the PowerShares Senior Loan Portfolio ETF (BKLN) as it might help us navigate both the Dividend Growth Newsletter portfolio (and the new High Yield Dividend Newsletter portfolio) through what could become a prolonged rising-interest rate environment. The performance of the PowerShares Senior Loan Portfolio hasn’t been great since it peaked in June 2013, but the ETF hasn’t been that volatile either, bouncing between $21.50-$25.50 since 2012. A reading of the product description of this ETF draws us to it, and we think it makes sense given our views on rising interest rates and in the context of an already-diversified Dividend Growth Newsletter portfolio. Its distribution rate is ~4%. Here’s what has caught our eye:

The PowerShares Senior Loan Portfolio tracks the S&P/LSTA U.S. Leveraged Loan 100 Index – providing fixed-income investors with attractive yield potential, while mitigating the risks of rising interest rates.

The PowerShares Senior Loan Portfolio tracks the S&P/LSTA U.S. Leverage Loan Index, comprising the 100 largest bank loans with floating rate coupons. Unlike fixed-rate instruments, the coupons of floating rate bank loans adjust upward as interest rates rise – providing investors with the potential of an attractive source of current income.

With their floating rate coupons and low durations, senior loans may offer compelling yield potential.

Wrapping Things Up

We think the next 30 years may be among the most difficult investors have yet seen. If tax rates can be cut, then surely they can be raised again, especially if the US enters into a natural recession and tax receipts come up decidedly short. Under that scenario, we’d expect government yields to rise (as the cost of sovereign borrowing increases), and that may put tremendous pressure on interest-rate sensitive financial instruments. We’re not talking about a doomsday scenario, of course, but even a 20-30% “correction” in the equity markets in coming years might be devastating for some, even if it is only a fraction of what has been gained back since the depths of the March 2009 panic bottom. We want you to be aware of the real risks. Please keep paying attention to your money!

Here is a summary of the changes in the respective simulated newsletter portfolios:

Dividend Growth Newsletter portfolio

Remove all of VNQ at $82.36

Remove all of PPL at $30.86.

Add 5% of IDV at $33.55.

Add 3% of BKLN at $23.00.

Best Ideas Newsletter portfolio

Remove all of XLU at $52.31.

We’re available for any questions!

Related dividend ETFs: DFE, DWM, DTH, FDD, SDIV, DWX, PID, DTN, LVL, FGD, DOO, DOL, DEW, IDOG, DVYA, DNL, IQDF, QDXU, IQDY, FIEG, WDIV, IQDE

ProShares inverse bond ETFs: TBF, TTT, TBX, PST, SJB