Higher for longer – are interest rates “double trouble” for dividend strategies?
Editorial by Thomas Meier
14.11.2023
The capital market has seen a meteoric rise in interest rates in recent times. In a world in which higher interest rates for longer are becoming a fact of life, capital market participants are facing a new investment reality with complex implications. Various asset classes are vying for the favour of investors, increasingly bringing to the fore Voltaire’s aphorism “perfect is the enemy of good”.
In this changing investment reality, fixed-income alternatives to equities are becoming more and more popular. The money and bond markets are offering nominal interest rates that savers have been yearning for in recent years. However, the real rate of return, i.e. inflation-adjusted earnings, often gets overlooked. Even at current bond yields, adjusting for inflation results in a real loss of purchasing power. Comparing bond and dividend yields, the huge disparity that has existed for years has shrunk significantly in favour of bonds. However, we must take a critical look at this first trouble. Firstly, inflation-adjustment must be considered. In this respect, companies have the option of increasing their dividends. Secondly, the combination of dividends and upside potential is what gives them their fundamental advantage over bonds.
The second trouble also comes down to the rise in interest rates. Companies’ cost of refinancing has increased significantly. Whereas just a few years ago companies were able to obtain refinancing cheaply, the cost has almost tripled in some cases depending on the risk and term involved. The higher cost of refinancing will have major implications for capital allocation because companies will have to spend a higher proportion of their cash surpluses on interest payments, leaving less for investment, dividends and share buybacks. Companies with high levels of debt or refinancing costs would therefore have to question their dividend policy and the sustainability of their dividends. This once more underscores the need for a fundamental analysis of ability to pay dividends, including when selecting securities for dividend strategies, as it is in times of growing economic uncertainty in particular that margin resilience, adaptability and speed of adaptation as well as a sound balance sheet are decisive factors in company selection.
Going from zero interest rates to higher interest rates is also problematic from the point of view of risk. Negative correlation between bonds and equities, as seen historically and in the textbooks, is not there at the moment. Since the turnaround in interest rates in particular, correlation has been positive, which means that bonds are not an efficient way of achieving a high degree of risk diversification. After a 30-year bull run in bonds, there are signs that a multi-year bear market is starting. Market participants should therefore be cautious about high yields for long-term bonds.
The current adverse conditions on the capital market with interest rates trending higher in the long run are a putative headwind for dividend strategies. That said, investors should not fall back into old habits and disregard the medium-to-long-term advantages of equities. Equities have proven to provide outstanding asset protection in the past and are likely to do the same in future. Inflation-adjusted interest-bearing securities are not a genuine alternative to nominal bonds. In contrast, dividend securities not only offer upside potential but also the possibility of sharing in dividends. In selecting dividend securities, not only is the absolute amount and payment of the dividend important but also the company’s long-term ability to pay dividends, taking into account high interest expense and economic challenges. In addition, many companies who traditionally pay dividends operate in defensive sectors, putting their ability to pay dividends on a solid footing in turbulent times. For investors seeking a long-term investment strategy based on solidity and sustainability, the dividend fund MainFirst – Global Dividend Stars is an attractive investment opportunity. The fund features tried-and-tested dividend strategies and careful selection of investment instruments, opening up the possibility of long-term, competent capital investment.
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