The Bank of England released the latest interest rate decision at midday on 22 June. The committee decided to raise the base rate from 4.5% to 5%. The initial reaction from the stock market has been a knee-jerk lower. In fact, the FTSE 100 is now down 1% on the day, sliding below 7,500 points. Despite what may seem lots of doom and gloom, I feel it presents a rare opportunity right now.
Why high rates are bad for the market
Interest rates in the UK are now at the highest level in decades. The hikes act as a negative impact on stocks. The vast majority of companies have some form of debt. This could be in the form of bank loans, bonds or other borrowings. Ultimately, the rate of interest that the firm has to pay on this debt is broadly linked to the base rate. With higher rates, it makes it more expensive for the company to issue new debt.
For businesses that sell directly to consumers, high interest rates present another problem. The squeeze on disposable income has hit people hard. With inflation making it more expensive to live, higher rates (meant to bring down inflation) currently aren’t working that well. Naturally, consumers are going to cut back on spending, something that’s already been seen this year. This reduces revenue for the businesses and puts pressure on the stock market.
The once-in-a-decade play
The niche that this opens up is that some investors are simply selling all stocks in the FTSE 100. The truth is that not all companies are that negatively impacted by these higher rates. This could be due to low debt levels or selling essential goods/services. Yet the share prices have still taken a bit of a hit recently, with Thursday being another example. At the moment, only nine shares in the FTSE 100 are up on the day!
I think this opens up a great play for income stocks. For companies that aren’t overly impacted, financials should stay strong and dividend payments should continue. Due to the share price falls, it pushes dividend yields higher.
Therefore, I believe investors can take advantage and lock in the generous dividend yields currently on offer. In theory, when the market turns to being more optimistic, or if we get rate cuts next year, the shares should rally.
This should provide capital gains from the share price. However, the dividend yield would fall in this case. Yet because of buying when the stock was low, the investor will have locked in the historically higher yield (assuming the dividend per share payment hasn’t changed).
Points to note
The main risk to this view is if we see continued hikes from the Bank of England beyond what we currently expect. It could be that the stock market falls further in coming months, providing an even better time to buy. If investors purchase now, it could mean holding an unrealised loss in the short term.
Ultimately, perfectly timing the market is impossible. Yet from where we currently stand, I believe this is a rare chance to invest in high-quality dividend shares.
