Worried About Dividend Cuts? Watch Debt!

Rising interest rates are amping up the pressure on earnings and balance sheets.

It’s fair to say dividend investing hasn’t exactly been very popular so far in 2023. With S&P 500 in the black by double-digits, the iShares Select Dividend ETF (NYSE: DVY)—used as a benchmark for dividend stock portfolios—is actually underwater by almost 5 percent.

Contrary to misguided conventional wisdom, dividend-paying stocks have historically rallied longer and stronger in years when interest rates have risen. And perhaps equally surprising, the worst performances have coincided with years of falling interest rates.

The reason is the economy. Like all stocks, dividend payers do best when growth is strong and earnings are correspondingly rising. Conversely, while yields provide some cushion against downside  risk, recessions ultimately send almost all stocks lower, whether they pay dividends or not.

Rising interest rates have historically coincided with strong economies when demand for money is high. That was generally the case in the first half of 2023, though the harder the Federal Reserve has pushed, the more weakness has popped up.  

Manufacturing and trade is now slumping along with banks and commercial real estate. And with the Fed seemingly set on more rate increases, rising interest expense is shaping up as a critical second half flash point for investors.

Most companies have already suffered several quarters of year-over-year increases in interest expense. And it’s a safe bet the calendar Q2 numbers due out over the next month or so will bring more of the same, with the blow falling hardest on those with high levels of debt to refinance and/or that rely heavily on variable rate debt.

Remember when the “advice” of mortgage lenders was to “borrow all you can afford?” Much of corporate America has taken that same advice in recent years—piling up mountains of debt with interest rates at multi-generation lows, including to fund stock buybacks.

Interest payments on long-term, conventional fixed rate mortgages never change. And provided borrowers stay current, principal is amortized or paid down until the loan amount is zero.

Some corporate borrowings are structured the same way. Atlantica Yield (NSDQ: AY), for example, owns a global portfolio of renewable energy facilities, power lines, natural gas-fired power plants and water infrastructure. Each project is financed individually with loans that amortize over the life of long-term contracts for service.

The effective interest cost to Atlantica never changes. And when it’s time to renew contracts there’s no debt, other than what management deems worthwhile to borrow for upgrades.

The vast majority of corporate debt maturing this year, however, will need to be refinanced at par value. And the cost is sure to be significantly higher, even for companies rated “investment grade,” or BBB-/Baa3 and up by major raters S&P, Moody’s and Fitch. Borrowers rated below that or “junk” will pay considerably more.

If this added cost is not offset elsewhere, it alone may be enough to drive credit rating downgrades. A recent study by Bloomberg Intelligence identified $500 billion of bonds with BBB ratings—two steps above junk—that are at risk of a cut to junk later this year. That means even higher borrowing costs for affected companies, particularly as elevated recession risk increases credit risk concerns and therefore the added yield investors will require to buy junk bonds.

Bottom line: Companies are increasingly concerned with maintaining investment grade ratings, and more broadly preventing rising interest expense from undermining earnings, balance sheets and long-term business plans.

That basically means cutting debt. And when management can’t get the needed funds from free cash flow, asset sales or cutting costs, the easiest option will be reducing or even omitting dividends.

Despite mounting pressure from rising interest rates, we’ve seen relatively few dividend cuts so far this year. Just 7 of the 174 utilities and essential services companies I track in Conrad’s Utility Investor, for example, pay out less than they did a year ago. And Australia’s AGL Energy (ASX: AGL, OTC: AGLXY) is already reversing cuts.

A roughly equal number of the 150 or so companies we cover in Energy and Income Advisor have done the same. And only a handful of office landlords have cut out of the 90 or so companies highlighted in our REIT Sheet.

Nonetheless, rising interest rates and recession risk have raised the danger of a significant uptick of cuts in second half 2023. Here’s what’s important to watch for:

·      Amount of debt maturing between now and the end of 2024, by which time the tightening cycle should be over and opportunities to borrow/refinance potentially much improved.

·      Debt at variable, floating and adjustable interest rates, the cost of which rises when the Fed pushes rates higher.

·      Bonds where interest costs are exposed to changes in currency exchange rates.

·      Offsetting factors such as balance sheet cash, expected asset sales and projected free cash flow generation after dividends are paid, which can pay off debt without refinancing.

Market history is clear that if a dividend paying company can stay solid on the inside during a recession/market decline—maintaining and preferably raising its dividend on schedule—its stock price will be among the first to recover when conditions inevitably become more positive.

On the other hand, companies that cut often have a tough time making it back. And in some cases, a reduced dividend is just a warning sign of much worse to come.

It’s rarely been more important to know the difference.