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Dividend-Paying Stocks No Longer Follow Interest Rates

By Roger Conrad on October 21, 2011

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When interest rates rise, dividend-paying stocks go down. When interest rates fall, dividend-paying stocks go up.

That little bit of conventional wisdom has been accepted as gospel by most investors for the 26 years I’ve been in the investment advisory business–and almost surely long before that. In fact, investors have often made it a self-fulfilling prophecy, selling dividend-paying stocks when they’ve been worried about rising interest rates and buying them back when rates have fallen again.

That’s what happened every spring and summer from 2003 to 2007. Each year, investors got more bullish on the economy early in the year and benchmark yields like the 10-year Treasury’s headed higher. Utility stocks, real estate investment trusts and virtually every other dividend-paying security fell sharply. Then growth seemed to cool, the benchmark yields fell, and investors came back, pushing prices higher.

That relationship broke apart abruptly in 2008. The benchmark Treasury yield did plunge in the second half of the year. But rather than rally full out, dividend-paying stocks crashed along with the rest of the market.

The reason: The severity of the market crash/credit crunch/recession–the worst since the Great Depression of the 1930s–raised concerns about companies’ ability to continue paying dividends. Investors re-priced dividend-paying stocks according to the perceived risk to dividends, with the result that prices plunged and yields soared at the same time so-called benchmark yields were falling.

The crash of 2008-09 showed clearly that dividend-paying stocks weren’t interest-rate sensitive but economy-sensitive. And that point was again proven in the historic rally that followed the crash. Beginning in early 2009, dividend-paying stocks across the board staged a mighty rally, even while 10-year Treasury yield was rising from a low of around 2 percent back towards 4 percent.

Not only were so-called interest-rate sensitive stocks not following interest-rate trends. They were moving in precisely the opposite direction. Rising interest rates were bullish, not bearish, and falling rates were bearish, not bullish.

If anything, this bust up of conventional wisdom has played out even more starkly in the stock market selloff we’ve seen since late spring. At the same time the 10-year Treasury yield has fallen well below 2 percent, dividend-paying stocks have tumbled. And since early October, as stock prices have recovered, the 10-year yield has again poked above 2 percent.

What’s going on here? Basically, there’s a new dynamic for dividend-paying stocks as well as income investments in general. Interest rates don’t call the tune. Instead, markets are constantly re-pricing risk for anything paying a dividend.

Contrary to the crash of 2008, not every stock or bond this side of Treasuries is crashing when the fear level rises. A large number of US utilities, for example, have recently hit all-time highs, including Dominion Resources (NYSE: D) and Southern Company (NYSE: SO). Many more are hitting 52-week highs and even post 2001-02 crash highs, including CMS Energy (NYSE: CMS), NiSource (NYSE: NI) and Xcel Energy (NYSE: XEL).

Not only did these stocks not suffer big losses over the summer and in the wake of S&P’s August downgrade of US Treasury debt. But they’ve rallied sharply thus far in October, as the US economy has continued to putter along and defy (at least thus far) forecasts of a relapse into recession. That’s clearly not interest rate-sensitive behavior, and it reflects a greater appreciation for these companies’ underlying business strength, i.e. lack of exposure to the potential for tighter credit conditions and revenue that’s steady even in the face of recession.

US power utilities actually demonstrated these strengths during the crash of 2008-09, with only two companies–Ameren Corp (NYSE: AEE) and Constellation Energy Group (NYSE: CEG)–cutting dividends as a result of the crisis. Both owed their weakness to excess leverage and lower revenue at unregulated operations, policies virtually all of their peers had shunned since the 2001-02 crash. And one dividend cut was as far as it went for both companies. Ameren’s recent dividend increase points to its growing stability, as does Constellation’s merger-in-progress with Exelon Corp (NYSE: EXC).

US utilities have, therefore, earned their creds in the eyes of investors. It’s hard to argue their dividends are as safe as US government debt. But they are a lot higher and growing besides.

US utilities, however, are far from the only companies that have positioned themselves against a worse case scenario for credit conditions and US economic growth. I see the same strength in pipeline companies, both the master limited partnerships (MLP) that are using low-cost capital to expand rapidly and those still organized as corporations.

Income flows from fees that proved their resilience during the crash of 2008, when oil prices fell from over $150 to less than $30. And that’s of course a far cry from the relatively minor dip in North American oil prices we’ve seen since the summer. And keep in mind that West Texas Intermediate crude is only one measure of global oil prices. Brent crude is the effective price in most of the world, and it has never fallen below $100 a barrel during the recent selloff.

Brent’s strength is one reason I also put Super Oils like Chevron (NYSE: CVX) in the utility-like category. These companies’ profits do rise and fall with energy prices. But with finances as strong as most countries’, their dividends and balance sheet strength can withstand virtually anything. Investors appear to have caught onto this, however, as share prices never really fell much this time around. But anytime they do, it’s a good time for risk-averse investors to pick up shares.

Not every dividend-paying stock, however, is awarded that degree of respect. Even during the 2008-09 crash, most companies were able to maintain their dividends. That was definitely true of communications companies, including rural wireline firms that pay huge yields out of cash flow.

But their performance as businesses during those extreme conditions has gotten them little respect in 2011, as investor fears of a reprise of 2008 have grown. Windstream Corp’s (NYSE: WIN) free cash flow, for example, covered its dividend by nearly a 2-to-1 margin. Yet it now yields well north of 8 percent again.

Yields on shares of Alaska Communications (NSDQ: ALSK), Frontier Communications (NYSE: FTR) and Otelco (NSQ: OTT) have climbed well into double-digits. Investors have literally ignored repeated statements by management that operations are healthy and dividends are well covered with cash flow in favor of speculation that things are falling apart.

What’s at work here obviously has nothing to do with interest rates. Rather, it’s simply re-pricing of investor perceptions of risk to dividends paid by these companies. And as economic conditions have weakened, the belief has grown that wireline communications companies’ sales and cash flows will fall in coming quarters.

That hasn’t happened so far. And if it does not, investors will eventually re-price the risk in these stocks to a lower level. That will push the prices of these stocks higher and, given the large number of short-sellers in some, the upside could be quite jagged indeed once it starts.

The re-pricing of risk has created a major trading opportunity for dividend-paying stocks and other income investments. That’s basically by betting against the prevailing market sentiment on risk. When investors .are more confident in the economy’s prospects, they’ll price risk at a low level. The trade there is to go short companies that don’t reflect enough risk and that will be sold off as investors price in more risk. The idea is to go long or buy when investors are pricing in too much risk. When conditions improve, perceived risk will drop and share prices will rise, in many cases in an exaggerated way as short-sellers are squeezed out.

We’ve seen this cycle actually play out several times since the markets began crashing in 2008. The selloff when worries about Europe’s sovereign debt first surfaced in 2010 were a great trade, first to go short as risk perception grew, and later to go long as it waned.

Some monster gains have been made this year betting that perception of risk would rise. Most of the companies that have sold off on higher perceived risks will hold it together as businesses. Consequently, they’ll rally when risk perception falls. The key is being able to identify which will hold it together, which becomes progressively more difficult the higher current yields are. Sometimes, after all, the market’s worries do prove well founded, and companies really do flounder. Diversification is invaluable when that happens. And no conservative investor should be betting on super-high-yielding stocks unless they have a firm base of less-risky fare.

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There is one area where interest rates are important as ever to shareholder returns. That’s companies’ vulnerability to a near-term spike in rates, typically by having a large obligation to refinance or roll over in the near term. That’s one reason any companies purchased to bet on a re-risking of the markets should preferably have no debt maturities between now and the end of 2012, or at the very least such obligations should be only a small percentage of a company’s market value.

The most deadly combination is a large amount of debt due accompanied by a falling share price. Such conditions are a constant threat to subject companies to what amounts to a margin call, in which lenders literally force dividend cuts and worse by calling in some of a company’s debt. Large obligations aren’t necessarily harbingers of doom. But with so many stocks so cheap, there are plenty of high-yielding alternatives that will do just as well if things work out–but are protected against a total loss if they don’t.

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