How Do Interest Rates Affect Capital Markets?

How might the capital markets react to rising interest rates, and how is that going to affect your financial future? Everybody’s looking for yield, everybody’s looking for something that will pay something. What has happened is a lot of people have loaded up more and more on high-yielding dividend stocks. Now, as a rule, I’m a big fan of dividend stocks, mainly because it gives us fundamentals that we can measure.

Dividend stocks are going to be little bit more mature in their growth cycle. We can look at their history; see how they’re trading relative to their dividends today versus their history to see if they’re under or overvalued. It gives us a bit of a snapshot fundamentally. The problem is people have been trying to increase yield and they have been loading up on these higher yielding stocks and they have underperformed as of late, especially utility stocks.

Utility stocks have long been thought of as a good yielding instrument for income and good for countercyclical markets. (When the markets are down utilities continue to make money.) Utility stocks are likely to really struggle in a rising interest rate environment. Now, we don’t know when rates will go up, or even if they will. They are likely to go up some. We could be five years from rising interest rates really taking off and having inflation, we could be ten years off, or we could be three years off. Personally I think it is coming, we just don’t know when, but I do think they will go up some.

A lot of investment models you look at historically have looked at bond markets for the last 30 or 35 years and have returns that cannot be replicated. We have had a historic bull market in bonds. When interest rates go down, bonds go up, but when interest rates go up, bonds go down. When you’re looking at securities that focus on yield, and you’re limiting yourself to those, many of those could end up getting impacted in a rising interest rate environment.

Your financial plan, in my opinion, has got to be more diverse than that to look at total return, and to have some art involved, not just science, but art where you are considering what is the impact if and when interest rates go up. One thing we do know is that they cannot go down the way they have the last ten years. Investment vehicles that take advantage of decreasing rates mathematically cannot see the same increases over the next ten years. So be careful with a portfolio that focuses purely on yield. You could really get burned when rates go up.