Interest rates appear to have peaked, and traders are pricing in almost 100 basis points of cuts for 2024. That’s significant, meaning we could see the Bank of England base rate fall from the current 5.25% towards a more moderate 4%.
The relationship
Higher interest rates generally lead to higher discount rates. Discount rates are used in financial valuation models like the discounted cash flow (DCF) method to determine the present value of future cash flows.
As interest rates rise, the required rate of return for investors also increases. This higher discount rate tends to reduce the present value of future cash flows, potentially leading to lower stock prices.
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Moreover, stocks compete with other investment opportunities, such as bonds or savings accounts. When interest rates are high, fixed-income securities like bonds become more attractive because they offer relatively safer returns.
As such, investors may shift their money to stocks from bonds or other interest-bearing instruments when interest rates fall. In turn, this puts upward pressure on stock prices.
This relationship is arguably even more apparent with mature dividend stocks as they are frequently sought after by income-oriented investors due to their consistent dividend payments.
Yes, the market does price in movements in the interest rate. So we’re already seeing share prices push upwards. However, it’s likely that movements aren’t fully priced in. And I think now’s a good time to stock up on my favourite dividend stocks.
My picks
These are my picks — three stocks I’ve bought and may buy more.
Phoenix Group currently offers a 9.5% dividend yield. It’s among the strongest on the FTSE 100. The insurer, I believe, is often overlooked by investors who prefer the slightly safer looking Legal & General and its 7.7% dividend yield.
Phoenix Group has a little more debt than its peers. Interestingly, the company says it’s towards the lower end of its targeted leverage range, despite claims that it’s over-leveraged. Importantly, the debt maturity profile appears quite evenly spread.
Moreover, the company has a strong business model — historically focusing on purchasing and managing legacy products through to maturity — and has benefitted from positive trends in bulk purchase annuity.
Staying with insurance but looking across the pond, another option is Manulife Financial. The company earns 67% of its income from insurance, 19% from annuities, 14% from banking, and offers a 5.5% dividend yield.
The US-based insurer is also among the top company’s for profitability in the space. And its shift towards the fast-developing Asian market is helping accelerate growth.
Analysts have noted concerns that a change in management could pose a challenge for the company, with recent successes attributed to the firm’s c-suite.
My final pick is Lloyds. It’s seen some upward movement in recent months, but still offers a 5% dividend yield. Higher interest rates have presented multiple conflicting headwinds and tailwinds for the lender, and the risks associated with surging mortgage repayments remain for now.
However, falling rates should provide some much-needed respite, with credit losses hopefully improving. Moreover, we should see the bank’s hedging strategy deliver more than £5bn in revenue as rates fall.
