The Sector to Avoid if You Sold Your Bonds for Higher Yielding Stocks

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Using dividend stocks as a proxy for fixed income has been gaining traction as pundits continue to call for an imminent collapse in the “bond bubble.” Many investors have been, or are considering, selling their fixed income assets and buying dividend stocks because they have a fear of rising interest rates. On the surface this isn’t a horrible idea and will likely produce excess returns for those willing to take on a bit more volatility. You can also rest assured that at some point you will be put to an emotional test when equities are undergoing their usually ebbs and flows. Notwithstanding that, many investors are buying equities that are also at risk of losses if interest rates start rising. Selling your bonds and swapping into those stocks will likely catch investors off guard. Read on to see which stocks to avoid and add if you fear rising interest rates.

MLPs are the Most Vulnerable

Master limited partnerships become more popular with each passing year and it isn’t hard to understand why. Since 1996 the Alerian MLP Index has produced average annual returns of 16%. This is more than double that of the S&P 500 Index. There are several reasons for investors in MLPs to be concerned if interest rates rise. First, MLPs are overvalued on an absolute basis with distributable cash flow yields (DCF), money available for dividend payments, below historical averages. However, they do remain attractive relative to U.S. Treasuries. Historically, the Alerian MLP Index has averaged a dividend yield that is 3% higher than the current 10-year Treasury rate. Today, the Index yields 5.33% against a 1.92% Treasury rate. The spread of 341 basis points is above historical averages, but it doesn’t take a big move higher in Treasury rates for MLPs to become expensive on both an absolute basis as well as a relative basis.

Secondly, MLPs are highly leveraged and higher interest rates would hurt the bottom line more than other industries. Take industry juggernaut Kinder Morgan (NYSE: KMI) and its $40 billion market capitalization as a case in point. The company has approximately $31 billion in debt and reports that a 10% change in their weighted average interest rate would result in a $55 million reduction in pre-tax income. This means that if the average rate rises by 50% and goes from just over 4% to the high 6% range, then trailing twelve month net income of $715 million gets cut by $275 million. OUCH! Essentially, this is a $275 million reduction in dividend payments annually.

KMI has one of the best reputations in the space thanks to founder Richard Kinder, but is one of the most overvalued in an industry vulnerable to rising interest rates. First, the dividend yield of 3.7% is rather skinny compared to the Alerian MLP average which is in excess of 5%. But the best measure of valuation is distributable cash flow yield, which ultimately is cash that can be paid out as dividends. Every company reports this differently, but comparing companies can be easy by just taking (net income + depreciation) divided by price. In KMI’s case, it produces a DCF yield of 5.5% or a kind of adjusted P/E ratio of 18.2x. Compare that to ONEOK Partners (NYSE: OKS), a prominent midstream natural gas operator, which produced trailing twelve month net income of $805 million along with $208 million in depreciation. Against a market capitalization of $11.5 billion results in a DCF yield of 8.7%. This is more than 50% higher than Kinder Morgan.

While ONEOK provides more protection than other MLP offerings given a more modest valuation starting point, the entire sector is vulnerable to rising interest rates. This would make the diversified Alerian MLP (NYSEMKT: AMLP) a bad choice for investors fearful of such a scenario. In fact, this ETF should be avoided regardless of the interest rate environment given its high 4.85% gross expense ratio that includes a mandatory deferred tax liability. Since the ETF inception date on 08/25/2010, it has underperformed the index it is supposed to be tracking, Alerian MLP Index, by 27%. This is more than 7% per year!

Resource Plays will be Beneficiaries, but are Risky

Resource stocks have historically been big beneficiaries during periods of rising interest rates. Conversely, they tend to get beat up when rates persistently fall as is currently the case. The gold companies come to mind first and likely have the most upside, but I would avoid them as they are not good options for investors swapping out of bonds. These investors generally want a little lower risk profile. In fact, the entire resource play is vulnerable to a big collapse if deflation pressures persist. It is likely a good idea that investors swapping out of bonds make sure they don’t bit off too much risk and avoid this entire space.

Turn to Tech

One option to get some yield and not get blind-sided should interest rate start rising is to buy some technology bellwethers. The yield on most viable technology options is just a little bit above 2% with some like Intel reaching into the upper 3% range. This graph below shows a couple options as well as the trend in yield- UP!

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MSFT Dividend Yield data by YCharts

Technology companies also have much higher credit ratings- an indication of bankruptcy probability. Investors using stocks as a proxy for bonds certainly don’t want to take on any elevated bankruptcy risk as a single instance could have dire consequences on the performance of the portfolio. Microsoft is rated Aaa by Moody’s Investor Service, the highest possible designation. Apple just received its debut rating of Aa1, the second highest possible rating. Cisco and Intel are both rated A1 whereas Qualcomm doesn’t even have debt outstanding. KMI, on the other hand, is actually a junk bond with ratings of Ba2. The principle subsidiary Kinder Morgan Energy Partners LP is rated investment grade at Baa2, but this is still four notches lower than Cisco or Intel. This stems from elevated leverage and limited liquidity as the majority of earnings flow out of the company in the form of dividends. MLPs constantly face refinancing risk even if they do own high quality assets.

The Foolish Bottom Line

If you selling you bonds for fear of rising interest rates make you sure you don’t step on an equity landmine. MLPs are the most vulnerable to such a scenario given their rich valuations, bond-like qualities, and higher credit risk. They aren’t the only industry as REITs, housing related plays, and to a certain extent utilities all may see weakness in a rising interest rate environment. One sector with less sensitivity to rising rates is the technology sector. Credit risk is minimal for the large players in the space and they have rising dividend yields as their elevated cash balances are being returned to shareholders with increasing willingness.

It's easy to forget the necessity of midstream operators that seamlessly transport oil and gas throughout the United States. Kinder Morgan is one of these operators, and one that investors should commit to memory due to its sheer size – it's the fourth largest energy company in the U.S. – not to mention its enormous potential for profits. In The Motley Fool's premium research report on Kinder Morgan, we break down the company's growing opportunity – as well as the risks to watch out for – in order to uncover whether it's a buy or a sell. To determine whether this dividend giant is right for your portfolio, simply click here now to claim your copy of this invaluable investor's resource.

Justin Carley has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan and ONEOK Partners, L.P.. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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