What is Going to Happen With Dividend Stocks When Interest Rates Will Rise?

Black Swan fans are always looking for the next bubble to burst

Here’s a theory for Black Swan fans; dividend stocks are the next bubble to burst and it will happen at the moment interest rates will rise.

 

Supporting the Theory

Since 2008, interest rates have dropped to the lowest level ever in North America. Insurance companies, pension plans, institutional investors and income seeking investors were all in the same basket; the lack of safe and reliable revenues from their investments. You can’t do much when 5 years bonds pay less than the rate of inflation. What can you do? Look elsewhere.

While dividend investing has always been very popular throughout the history, dividend stocks have caught more attention over the past 5 years. After the stock rebound in 2009 and 2010, dividend stocks appeared to be the next savior for income seeking investors. They realize that a well-diversified companies like Johnson & Johnson (JNJ) or Procter & Gamble (PG) are super stable companies generating more than interesting yields. At one point, some investors started to compare municipal bonds paying 2% for 5 years while JNJ and PG and a whole bunch of solid dividend stocks were paying over 3% in dividend yield. And the best part was the growth potential; strong dividend stocks will increase their dividend payment year after year on top of providing stock value appreciation. Wow… this sounds better than bonds, right?

And this is how massive amount of money started to fly away from bonds to be invested in dividend stocks. At that moment, we saw an increase in valuation multiples for several companies. Just look at the chart below:

increase div valuation

As you can see, the PE ratio increased significantly over the past 5 years for many stocks known for their strong dividend payment history.

What happens when valuation goes up like this? You are right; it has to drop as fast as it went up. Well… that’s the Black Swan fan theory anyways…

Once interest rates will start to rise, this important group of income seeking investors will rapidly sell their dividend paying shares to replace them with solid bonds paying decent levels of interest. If many institutional investors follow this trend, we will have a crash in the dividend stock world as we will see too many sellers for so little buyers.

 

I’m NOT Supporting this Theory

I don’t know if you are starting to think that I believe dividend stocks will be the next bubble to burst, but I’ll make it clear: dividend stocks are not a bubble. I’m not a big fan of Black Swan events and I don’t think the stock market will collapse due to overbought dividend stocks.

 

Not fast enough to create a crisis

The first reason why this scenario won’t happen is because interest rate won’t rise overnight to 5%. The FED is very cautious with the interest rate and this is why rates haven’t risen yet. It will happen in 2015, that is almost a certainty. However, rates won’t increase by 0.25% each month for the next 36 months either. The economy is not booming and the inflation rate is under control. Therefore, while a healthy economy requires higher interest rates, there are no reasons to boost rates like there is no tomorrow. This would probably do more harm than anything else anyways.

If the interest rate goes up slowly, there won’t be a massive movement of cash going out of dividend stocks to buy bonds. It will be done slowly and massive share buyback programs authorized within the same dividend paying companies will probably be enough to compensate for the outflow.

 

Dividend stocks remain strong companies

It is true that we have more investor types that invest in dividend paying stock these days due to lower interest rates. However, dividend stocks are popular for a very simple reason; dividend stocks are strong and reliable businesses generating constant cash flow. Therefore, it’s also normal that their valuation multiple increased over the past 5 years. A good part of this was simply the dividend stocks following the general stock market trend where investors are more optimistic about future growth in general. This is not a phenomenon that implies solely dividend stocks.

Also, there is a basic reason why most companies that pay a dividend do it; it’s because they have a solid business model enabling them to do so. And this solid business model won’t collapse if some investors sell their stocks to buy bonds. Solid fundamentals won’t be affected and if the stock price drops, it will only be a great buying opportunity.

 

Final thoughts on this potential bubble

I can’t guarantee there won’t be a panic movement around dividend stocks at one point. You know Mr. Market’s mood swings are pretty violent some times. However, I don’t see a valid reason why dividend stocks would lose value over the long haul. Therefore, if there is a storm, the dividend payment will protect you in the meantime and the sun will shine again.

If you can put some cash aside (I’m not saying you should sell, but rather save more money for the next round!), I think we will see a great buying opportunity coming shortly! Thx to the Black Swan fans!!

What do you think? Do you expect dividend stocks to drop suddenly once interest rate starts to rise?

 

Disclaimer: I own shares of JNJ and KO