Low interest rates have been a boon for most families. Home affordability is close to a multi-decade high, the stock market has more than tripled since its lows and millions of households have been able to refinance their mortgage loans, which in the process has saved thousands of dollars a year. That said, this prolonged period of ultra low rates has had a downside, particularly for retirees: It has become increasingly difficult to find assets that generate a respectable stream of income.
While rates remain extraordinarily low by historical standards, in the last few months we have witnessed a modest change in the environment. The 10-year U.S. Treasury yields have risen by nearly a full percentage point from the January lows, and short-term rates are starting to climb as well. This has led to more stock market volatility, but there are potential upsides to higher rates.
More income on cash
Since January 2009, the average yield available on a 3-month Treasury Bill has been 0.08 percent. At this rate, an investor would earn approximately $0.80 of interest per year (before taxes) on every $1,000 invested. The collapse in money market rates has led to a corresponding collapse in the income Americans are able to generate on their savings. Personal income from interest was about $1.39 trillion on the eve of the crash. While it has stabilized in recent years, today interest income remains roughly $130 billion below its pre-crisis peak (see chart below). That works out to about $1,050 per year of lost income for every household.
Better valuations for dividend stocks
In their search for yield, investors have bid up dividend stocks to unprecedented levels. For example, in January the U.S. utility sector was trading at a 5 percent premium to the broader market. Prior to 2009, utility companies typically traded at a 25 percent discount. That discount reflected the regulated, slower growth characteristics of the industry. The newfound premium (since reduced), on the other hand, is the result of investors seeking investments that can offer lower volatility and higher yield. In an environment of low rates, that yield becomes even more valuable. However, as rates begin to normalize, valuations on utility stocks, as well as other dividend-paying sectors, are likely to come down—a process already well underway. This should create a better entry point and value proposition for long-term investors.
It is true that higher rates will probably bring about more volatility and dislocation for both stocks and bonds, but we think the impact is unlikely to be severe. Assuming rates are rising because the economy is strengthening and the rise is modest, higher rates should not signal the end of the bull market. And for those focused on income, it will make the search for yield a bit less arduous.