In recent years, interest rates have dominated virtually every economic conversation. They were forced to move higher to control the rise in inflation, remained center stage as rising costs of living collided with higher borrowing costs, and now remain in the spotlight as investors await long-awaited cuts.
The problem is that they can also be confusing for some investors. When interest rates rise, certain sectors stumble. When interest rates fall, others take off. So to understand which dividend stocks can hold up through rate cuts, it helps to understand the basic mechanics.
How do interest rates work?
Essentially, central banks raise interest rates to pull money out of the economy, for example during periods of rising inflation. Raising interest rates makes borrowing more expensive, raises returns on stocks and bonds, and generally lowers stock valuations. In addition, companies with significant debt burdens also face shrinking margins as their interest costs rise.
On the other hand, if interest rates are lowered, borrowing becomes cheaper, so economic activity tends to pick up and the discount rate used value future cash flows drops.
That combination tends to drive stock prices higher, especially for companies that rely on steady cash flows or have large amounts of debt. In fact, lower interest rates pushing up valuations are one of the main reasons why the market has performed so well this year.
So the good news for investors is that most Canadian dividend stocks actually benefit when interest rates start to fall.
That said, not every sector experiences rate cuts in the same way. One area where the impact is more mixed is the financial sector.
What are the consequences of interest rate cuts for the financial sector?
While interest rate cuts help improve the valuation of all stocks due to the lower discount rate used to value future cash flows, companies in the financial sector may experience mixed impacts from lower interest rates.
Banks, for example, may come under pressure net interest margins because interest rates on loans are falling faster than deposit costs. That said, lower interest rates also reduce the frequency of underperforming loans, so even bank stocks could see their business positively affected by falling interest rates.
Meanwhile, insurance companies may also experience slight headwinds from lower interest rates, as they typically earn less on the fixed-income portfolios that support their long-term liabilities.
Which dividend shares are best to buy now?
However, the majority of stocks will benefit from lower interest rates, whether this is due to rising valuations across the board, fewer interest charges impacting profit margins, or more money in the economy being used to consume goods.
That’s why now is one of the best times for investors to buy high-quality Canadian stocks, especially those trading below fair value.
For example, many stocks in the real estate sector continue to trade ultra-cheap due to the impact that higher interest rates have had on their businesses.
Killam Apartment REIT (TSX:KMP.UN), a $2 billion residential REIT, is a perfect example. Not only does the stock trade at a forward price-to-funds-from-operations (P/FFO) ratio of 13.2 times, which is significantly cheap for a residential REIT. But that’s also well below the five-year average forward P/FFO ratio of 16.1 times. Moreover, it is the current forward dividend yield of 4.4% is also significantly higher than the five-year average forward return of 3.9%.
Plus, in addition to Killam, there is a residential REIT that is even cheaper Minto REIT (TSX:MI.UN), a roughly $500 million company with properties in major cities across Canada.
Minto is currently trading at a forward P/FFO ratio of 13.8 times, which at first glance seems higher than Killam. However, the five-year average forward P/FFO ratio is more than 20 times larger, showing how cheap Minto is trading today.
So if you’re looking for high-quality stocks that trade cheaply, I’d quickly consider these top dividend stocks before interest rates continue to fall.
#Dividend #Stocks #Canada #Survive #Rate #Cuts