“Higher For Longer” Is Totally Unsustainable: Buy Defensive Dividend Stocks

Dividend stocks have seen an absolute shellacking over the last year.

The four defensive, debt-utilizing sectors of renewable power production (RNRG), real estate (VNQ), Utilities (XLU), and Consumer Staples (XLP) have sold off hard as interest rates have surged.

In the last month, long-term interest rates in particular have spiked. Corporate bond (LQD) yields, as measured by the effective yield on BBB-rated bonds, have surged to a new high, as have the 10-year and 30-year Treasury bonds.

As I write this on Friday, October 6th, dividend stocks are getting some relief from the selling and enjoying a green day. Whether it will last is questionable. After all, the primary reason for the dividend stock selloff — rising interest rates — persists. Treasury yields across the curve were uniformly up on Friday.

Federal Reserve officials’ statements, quantitative tightening (the Fed selling Treasuries), and the federal government’s deficit spending / debt issuance continues to ratchet up long-term interest rates further and further.

The rising rates trends seems to have taken on its own momentum. Pundits and practitioners alike are out making increasingly implausible projections about how high interest rates could go from here, from Jamie Dimon’s statement that the Fed Funds Rate could go to 7% to Rick Santelli’s statement that, based on chart technicals, Treasury bond yields could go to 13%.

Every time we see a sharp movement of anything in the financial markets, from a stock to a sector to a cryptocurrency, pundits come out of the woodwork to make absurd claims about how far the trend will go.

I am reminded of Bitcoin’s sharp run in early 2021, when pundits emerged to confidently claim (using what data?) that the price of Bitcoin would go to $100,000, $500,000 or maybe even $1 million. The same investor psychology appears to be at play right now with interest rates.

In what follows, I want to demonstrate why “higher for longer” interest rates are totally unsustainable over any significant length of time, and why high-quality, defensive dividend stocks are eminently buyable today.

Impact On The Government Budget

Someone should probably tell the United States Congress about the Fed’s “higher for longer” plans, because the federal government does not appear to have gotten the memo.

Despite rising interest rates usually being a catalyst for economic actors to rein in spending and deleverage, the federal government is doing the opposite. Somewhat concerningly, this is occurring in the midst of “full employment” with the unemployment rate near all-time lows.

Over and over again, I hear comments to the tune of, “Interest rates at their current level are not high, historically speaking. They’re average, if not a bit low.”

But these kinds of comments are totally divorced from any relevant context, most notably debt levels.

Sure, a 10-year Treasury yield of 4.8% does not seem high if you simply look at a long-term chart. But if you adjust for the debt levels, 4.8% is extraordinarily high!

The last time the 10-year Treasury bond yielded 4.8%, federal government debt to GDP was roughly half of where it is now.

You might think that the government has a money printer and infinite ability to issue debt, so what’s the problem? The risk of default is zero.

The problem is threefold:

• Higher interest rates and a larger debt load indicate that interest expenses will soar, which will likely result in even more debt. Ample economic research demonstrates that excessive government debt weighs down economic growth.
• Continued deficit spending in the face of rising interest rates diminishes the government’s fiscal capacity to absorb future shocks such as recessions or entitlement program insolvencies.
• The sharp political division in the US increases the risk that, rather than technically defaulting on its debt, the US Government will endure more frequent and protracted government shutdowns, triggered by the need to regularly lift the debt ceiling because of persistent deficit spending.

The ratio of federal government interest payments to tax receipts has already surged to its highest level in nearly three decades as of Q2 2023:

This is only the beginning. Interest expense as a share of tax receipts is guaranteed to explode higher in the coming quarters, as about 30% of federal government debt is scheduled to mature over the next 12 months.

To quote the New York Times,

The Treasury Department has sold close to $16 trillion of debt for the year through September, up roughly 25 percent from the same period last year, according to data from the Securities Industry and Financial Markets Association. Much of that issuance replaced existing debt that was coming due, leaving a net debt issuance of around $1.7 trillion, more than at any other point over the past decade except for the pandemic-induced bond binge in 2020. The Treasury’s own advisory committee forecasts the size of government debt sales to rise another 23 percent in 2024.

What is more likely:

• Congress cuts spending and/or meaningfully raises taxes, or
• The Federal Reserve cuts interest rates and resumes its government bond-buying program in order to accommodate fiscal deficits?

Impact On The Business Sector

How about the private side of the economy?

It is true that corporates gorged on cheap, long-term debt in 2020 and 2021 and refinanced many of their upcoming debt maturities. But there remains a steady slate of debt maturities yet to be refinanced, and they’ll have to be rolled over at much higher interest rates.

Going back to the “interest rates are not historically high right now” notion, consider that the last time the BBB-rated corporate bond yield was at 6.5% (in 2007), nonfinancial corporate debt to GDP was at around 42-43%. Today, corporate debt to GDP sits at 48%.

Business Debt To GDP:

If corporations had little to no upcoming debt maturities, the greater corporate debt to GDP wouldn’t be a problem. But they do.

Through 2026, corporations face a growing wall of maturities, with each year including a larger and larger share of high yield and leveraged loans.

Refinancing for investment grade companies will be painful, but they’ll survive it. Many high yield and leveraged loan borrowers will not survive refinancing at current interest rates.

This is already the case, which is why the number of bankruptcies has reached recessionary levels.

I am sympathetic to the idea that many of these companies going bankrupt were corporate zombies only kept alive by the steady morphine drip of artificially low interest rates during the ZIRP era. Even so, their demise will wreak increasing levels of economic havoc going forward.

For the businesses that survive high interest rates, there will be broader economic consequences to higher interest rates than just hits to profits and stock prices. According to Goldman Sachs, for every $1 of increased interest expense, capital expenditures decline by 11 cents and labor expense decline by 21 cents.

About half of the negative effect of higher interest expense on labor costs comes from lower-than-otherwise wages. The other half comes from lower employment — i.e. layoffs.

What about the recently released bumper jobs report for September, showing 366K jobs added and a flat unemployment rate of 3.8%?

It’s crucial to remember that employment is a coincident or even lagging indicator. Unemployment doesn’t usually start to tick up until after the recession has already begun.

Plus, the September jobs report also shows that the bulk of added jobs came from non-cyclical parts of the economy such as education, healthcare, and government. Thus, the strong jobs report doesn’t really illustrate where the economy is going in the future.

As economic activity declines amid a tidal shift in corporate spending from capex and labor to deleveraging and cost cutting, is it likely that interest rates just keep rising higher and higher without any reversal from the Fed?

Impact On The Housing Market

Lastly, consider the effect that “higher for longer” would have on the housing market and home affordability.

Once again, the objection that “a 30-year mortgage rate of 7.5% is historically average” is totally divorced from the context of home prices.

Amid an ultra-low supply of homes on the market, home prices have not fallen and in some cases have continued to rise. Combining this with the highest mortgage rates in over 20 years, you get the lowest housing affordability in nearly four decades.

This chart is from July. Since then, both mortgage rates and home values have only risen (see the NAR’s September 2023 Housing Market Report), which means that real-time homebuying affordability is probably close to its early 1980s lows.

On top of that, Zillow is forecasting that home prices will rise another 6.5% in the next year!

The NAR report estimates that, in September 2023, the monthly mortgage payment for a median priced home increased 12.4% YoY, which far outpaces wage growth of 4.3% and inflation of 3.7%.

The few sellers out there (many of whom have to sell for one reason or another) typically don’t have to lower prices or accept below-asking offers in order to sell, because there are plenty of downsizing Boomers with plenty of home equity as well as 30-something Millennials getting help on the down payment from their parents.

Home sales have plummeted to their lowest levels since the Great Financial Crisis of 2008-2009, but this hasn’t led to a slide in home prices due to the aforementioned lack of home inventory.

A strong case could be made that the Fed is actually shooting themselves in the foot with “higher for longer” when it comes to housing. High mortgage rates (spurred by a high Fed Funds Rate) are suppressing both demand and supply, as homeowners don’t want to give up their existing 3% mortgage rate to sell their house and buy another one at a 7.5% mortgage rate.

Ironically, renters are now finally getting some relief on rent growth because of the abundance of new apartment supply deliveries. These apartment buildings were greenlit during the period of low interest rates in 2021 and early 2022.

There has been a sharp drop-off in apartment construction starts this year amid prohibitively high interest rates, which will eventually translate into a dearth of new deliveries and upward pressure on rent rates (i.e. housing inflation).

Does the Fed really want an economy where only downsizing Boomers and trust fund Millennials can afford to buy a home? Because, realistically, that’s what their “higher for longer” policy implies.

TL/DR: Why “Higher For Longer” Is Unsustainable

In short, then, my argument is that “higher for longer” interest rates are totally unsustainable over any significant period of time because:

1. It will have an increasingly negative effect on the government budget, which will ripple out into other negative economic effects.
2. It will incrementally weigh down profits, capex, and employment in the private corporate sector.
3. It will make homeownership affordability, already at multi-decade lows, even more out of reach, causing home sales volume to grind even further toward a standstill.

My Strategy: Double Down On High-Quality Dividend Stocks

My strategy is quite simple. In fact, it hasn’t changed one bit. The strategy is to:

1. Buy high-quality companies
2. that pay a growing dividend
3. at a discount to fair value (and thus an attractive dividend yield)
4. and wait patiently as they compound over time.

That’s it.

Quality companies and real estate will retain their value over time, and their stock prices will bounce back.

• If interest rates stay this high for a while, I’m buying at a very nice margin of safety, limiting my downside. Current high-yielding dividends should remain safe even as dividend growth is muted.
• If interest rates moderately decline from here, quality dividend stocks and REITs should outperform from here and grow their dividends at a steady, inflation-beating clip.
• If rates decline significantly back to very low levels in the coming years, quality dividend stocks and REITs should massively outperform, and dividend growth should be very strong.

During stock price routs like the current one, it’s beneficial to my sanity to focus on my ultimate goal of income growth.

In Q3 2023, my portfolio lost a lot of value on paper. But my portfolio-wide dividend income grew by 9.1% QoQ as a result of investing my saved income, reinvesting dividends, accretive portfolio recycling, and some special dividends.

I’m a firm believer that a “quality at a reasonable price” (“QARP”) investment strategy goes hand-in-hand with the financial goal of a growing passive income stream.

When you buy a wonderful company with a balance sheet and business model that protects the dividend, and you buy it at an attractive combination of yield and prospective dividend growth, your total portfolio income can and should keep growing even during bear markets and stock price crashes.

Plus, when you buy a wonderful company at a fair (or better) price, there’s a really good chance your paper losses won’t be permanent. When you buy fair companies (especially those with heavy debt burdens and/or non-investment grade credit ratings), it’s much more questionable whether your paper losses will ever turn to paper gains, almost regardless of the price you pay.

More specifically, my strategy right now is to buy the “baby thrown out with the bathwater” in the sectors that have seen the sharpest selloff. In other words, I’m focusing on the highest quality REITs, utilities, renewable power producers, and consumer staples that have recently dropped along with the rest of their respective sectors.

Here are four examples of high-quality, defensive dividend payers that I have been buying recently:

Extra Space Storage (EXR)

EXR is the largest and perhaps best-managed storage REIT in the US. It only recently surpassed Public Storage (PSA) to become the largest after its acquisition of Life Storage (LSI), which expanded its footprint in the Sunbelt region. EXR has a great balance sheet, and I think its fundamentals will recover once the housing market (eventually) recovers.

Sixth Street Specialty Lending (TSLX)

TSLX is among the higher quality business development companies, along with MAIN, Ares Capital (ARCC), and Capital Southwest (CSWC). Unlike its peers, TSLX has an unique balance sheet strategy of taking out fixed-rate debt and immediately swapping it to floating-rate. Thus, the BDC’s performance varies little whether interest rates are rising or falling. Between this interesting balance sheet strategy and management’s conservative investment underwriting, TSLX has turned in among the highest total return performance of all BDCs over the last decade or so.

NextEra Energy, Inc. (NEE)

NEE is a best-in-class utility company and renewable energy developer temporarily wounded by the problems in its YieldCo subsidiary, NextEra Energy Partners (NEP). The market seems to think NEE has lost its sole channel of growth — drop-downs to NEP. But I think the financial situation is much more flexible than that.

NEE has over $18 billion of interest rate hedges limiting the impact of higher interest rates over the next five years, and don’t forget that Florida Power & Light is among the most efficient and profitable regulated utilities out there!

PepsiCo (PEP)

Given PEP’s low debt and little by way of upcoming debt maturities, I believe the sharp selloff recently is mostly attributable to fears that the surging popularity of weight-loss drugs will put a dent in PEP’s snack food products. This feels like too hasty a conclusion, but even if it is true, PEP has ample flexibility across its brands and balance sheet to pivot to healthier foods, higher margin products, smaller packaging, etc.