3 Stocks To Thrive In The Higher Rate Environment​

The Fed Funds Target Rate, which controls rates and yields at the short end of the yield curve, has been set at 0% to 0.25% since December 2008. The economy has functioned under this basically zero rate policy for over half a decade. In the current market, any hint or expectation of a rate increase by the Fed has a tendency to cause stocks that pay attractive dividends to sell off as a group. In reality, there are high-yield stocks that would be hurt by higher rates and a great many that will do just fine or be even more profitable when interest rates finally do start to move up.

The Fed has put out the following rate expectations for next year and beyond. It thinks the Fed Funds Rate will average about 1.6% in 2016 and 2.9% in 2017. For a comparison, the Fed managed short-term rates in a range of 2% to 5% in the decade prior to the 2007-2008 financial crisis. The interest rate expectations for the next two years are quite modest, and probably do not justify the recent 20% sell-off in many high yield stocks. As an income investor, here are some factors you should watch for in the stocks you hold or want to buy for your portfolio.

Companies that have variable rate borrowing cost and use borrowed capital to fund fixed rate investments could face shrinking profit margins. The most egregious users of this model are the agency MBS finance REITs. These companies borrow in the short term market to fund the highly leveraged ownership of government guaranteed mortgage-backed securities – most of which carry fixed rates. These companies leverage up interest rate spreads of 1.5% to 2.0%, so you can see how the Fed’s rate forecast could squeeze the profit margins of these companies.

On the other side, companies that lend money with variable rates and have fixed or rate matched borrowing will do fine in a higher rate environment. The better commercial mortgage REITs that put out variable rate loans on commercial properties have demonstrated how higher rates will increase profitability. That doesn’t stop the market from lumping these companies in with their residential mortgage cousins and pushing down share prices. Don’t be afraid to buy or add to your commercial mortgage REIT holdings when prices are down.

Companies with investment grade credit ratings should be able to sustain their business models in a higher interest rate environment. Most high-yield companies use significant levels of debt to fund the purchase of assets and a strong credit rating allows a company to stick with its growth plans. A company with junk-rated debt may not be able to borrow money and then put it to work and earn enough to grow dividends paid to investors.

The best defense against rising interest rates is to own shares of quality companies that will increase dividends at a rate faster than the increase in interest rates. This includes companies like EPR Properties (NYSE:EPR), STAG Industrial (NYSE:STAG), and Lexington Realty Trust (NYSE: LXP). Current yields of 6% or more and annual dividend growth rates of 4% to 5% or higher will put you well ahead of the game when interest rates are again in more normal ranges, after 2017.