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.
