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Income Investors Shouldn't Panic As Rates Rise

By Charles Sizemore

What now?

This is the question on every income investor’s mind.  After a five-month start to the year in which income-focused investments went nearly parabolic, concerns that the Fed might—just might—start winding down its quantitative easing sent the share prices of REITs, MLPs, utilities, and other popular investments into a tailspin.

The MLP sector, as measured by the JP Morgan Alerian MLP ETN (AMJ) was down 5% from its May 20 close through the end of May, and REITs, as measured by the Vanguard REIT ETF (VNQ), were down more than 8% in that period. Looking at individual securities, the numbers get worse.

Realty Income (O), National Retail Properties (NNN), and Retail Opportunities Investment Corp (ROIC)—three REITs I hold in my Dividend Growth were down 17%, 14% and 10% respectively for this period. Martin Midstream (MMLP), a  high-yielding MLP I hold in the same portfolio, was down by just under 10%.

After dramatic reversals like these, it’s easy to panic. But let’s put them in perspective. Even after the late May bloodletting, all of these securities are positive for the year, and after including dividends all are up by even a higher margin. The price correction we saw was simply a shakeout, in my opinion. I personally believe, the “hot money” had run the prices of these securities up, and when the “hot money” abandoned them they simply wiped away the speculative froth.

Interestingly, REITs and utility stocks took a harder hit than master limited partnerships (MLPs). Though I have no hard evidence to support this, my theory as to why this happened was that MLPs tend to have greater ownership by individual income investors and tend to be less affected by the hot money’s changing moods.

So, back to the original question, what now? In an environment of rising rates, does a dividend growth strategy still make sense?

I believe it does, but only if you do it right. Sizemore Capital has very little exposure to bonds and no exposure at all to slow-growth income investments such as utilities. In this environment—and in any environment of non-zero inflation—future dividend growth is more important than the current payout.

This is why I am overweight in the sectors with what I consider the right mix of current income and potential growth in income - sectors such as retail REITs, mid-stream MLPs, and “Big Tech” companies such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO).

And to be clear, I am by no means certain that the rise in interest rates will go much higher than it already has in the near term. As the experience of Japan proved, market yields can stay low for much longer than anyone expects during a prolonged period of debt deflation and aging demographics.

But to the extent that rates do rise, you want to own assets that stand to benefit from an improving economy and that have room to raise their cash payouts at a rate that will keep pace with rising market yields.

On this count, I believe midstream pipeline MLPs and most categories of REITs qualify. Rising interest rates raise their borrowing costs and cut growth prospects at the margin. And because these securities have become bond substitutes of late, falling bond prices (i.e. rising yields) could possibly mean falling stock prices.

But given that the 10-year Treasury still only yields 2.1%, a 4%+ dividend yield and a high-quality real estate and infrastructure portfolio still makes them a preferred investments for income investors, who can tolerate some investment risk. We believe the dividend payout can be expected to grow over time with potentially modest risk of loss, whereas Treasuries are only considered “risk free” if you ignore inflation.

We may see more turbulence in dividend-focused investments as institutional investors rotate into more aggressive sectors. I’m ok with that, and I intend to use any further weakness as a potential buying opportunity.

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