Opportunities in a Rising Rate Environment

12/27/2016 9:00 am EST

Focus: DIVIDEND

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

We agree with the market that the Trump administration could be bad for long-term, high-quality bonds, and expect a continuation of the recent trend toward higher rates, explains fund expert Mark Salzinger, editor of The No-Load Fund Investor.

However, bonds of shorter maturities tend to lose much less than longer-term bonds during periods of increasing interest rates.

For example, Vanguard Short-Term Bond Index (VBISX) lost only about 0.9% in November.  Though yields of short-term bond funds still hover in the low 1% range, payouts will increase as maturing lower-yielding debt is replaced with higher-yielding issues.

Income investors also may want to consider floating-rate bond funds, including T. Rowe Price Floating Rate (PRFRX) and Fidelity Floating Rate High Income (FFRHX), both of which produced small gains in November.

These funds invest mainly in lower-quality debt that is nevertheless backed by specific collateral in case of default. Because the payouts adjust with only a slight lag to changes in short-term rates, the bonds have almost no interest rate risk.

The Price and Fidelity funds currently offer yields of approximately 3.9% and 3.5%, respectively, but these are likely to rise starting early next year.

Higher interest rates suggest a difficult environment for so-called yield substitutes within the equity market, including electric utility and telecommunication services stocks, as well as REITs, as their dividend yields become less attractive relative to bond yields.

However, while we are not especially optimistic about the latter two equity areas in the current yield environment, we think utilities are quite interesting.

A more relaxed regulatory environment for utilities, combined with a potential increase in demand for electricity, argue for increased profitability for this U.S.-centric sector.

This makes the Utilities Select Sector SPDR (XLU) a compelling purchase in the mid-40s or below, in our opinion.

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