Inflation is flipping the investment world on its head. Portfolios that were carefully constructed to reduce market risk are taking a beating as interest rates rise.
Consider utility stocks. They have long been considered one of the safest ways to invest in equities. Some people call them the bonds of the stock market because that’s how they behave. When interest rates rise, the share prices drop, just as bonds do. When rates fall, utilities stocks go up, as do bond prices.
I’ve often recommended utilities as a way to enhance income in a portfolio while reducing risk at the same time. The two Canadian companies with the longest history of consecutive annual dividend increases are Canadian Utilities Ltd. (CU-T) at 53 years and Fortis Inc. (FTS-T) at 52. Fortis is expected to increase its payout in November, which will put it at 53 years as well.
When you combine rising dividend increases with predictable income growth (utilities are regulated companies) and limited downside exposure, it’s clear why they have become key holdings in conservative, low-risk portfolios.
But to make them work most effectively you must buy at the right time. I’m not a great believer in market timing, but this is an exception. Buying interest sensitive securities when rates are on the rise is not a great idea.
In late July, the S&P/TSX Capped Utilities Index was at an all-time high of 421.92. Central banks were still standing pat despite concerns about high inflation. But long-term bond rates were moving higher, affecting mortgages, credit-card rates, car leases, etc.
That process has accelerated. Central banks, including the U.S. Federal Reserve Board, responded in September by raising short-term rates by a quarter point. At least one more increase is expected this fall.
The result is the highest long-term interest rates we’ve seen since 2002. And there is no quick fix in sight. We will be dealing with this problem for the foreseeable future.
Even though inflation has only been a top-of-mind concern since oil prices spiked after the start of the Iran war on Feb. 28, the damage it’s inflicted on stocks is significant. As of Oct. 2, S&P/TSX Capped Utilities Index was down 10.3 per cent from the July high.
Stocks are up and bonds are down. Uh-oh, it could be time to rebalance
The prices of utilities stocks have reacted accordingly. Canadian Utilities shares were trading at $56.90 in late July. The shares closed Friday at $51.42, down 9.6 per cent since the July high. Fortis has fallen from $83.75 to $75.31, a drop of 10 per cent.
Higher rates are a double whammy for utilities. These companies carry a lot of debt, which adds to their costs when rates rise. Meanwhile, higher yields on safe government bonds decreases the attraction of dividend yields. That puts downward pressure on share prices. Fortis was yielding 3.1 per cent in July; it’s now yielding 3.4 per cent because of the lower share price.
It’s not only utility stocks that are at risk. All interest sensitive stocks are experiencing the same problem. For example, the S&P/TSX Capped REIT Index has lost 11 per cent since its July peak. The telecom sector is off 21 per cent since March. Pipeline companies are also under siege; Enbridge shares are down almost 19 per cent since late July.
The message is clear. This is not the time to buy “safe” stocks if they are exposed to interest-rate risk. Unless you are heavily overloaded with them, I’m not suggesting you sell, as the cycle will turn again and the dividends will keep flowing. But I would not advise buying more at this point. Wait until there are signs inflation is easing, then add at what should be bargain-basement prices.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
Editor’s note: An earlier version incorrectly stated that the Bank of Canada was among the central banks hiking interest rates in September.