Grow Your Dividend Income Despite Inflation and Rate Hikes

Dividend Investing, Inflation, Interest Rates
Steps made of rolled-up dollar bills.

Dear Investor,

High inflation has become a driving force in our lives. It’s challenging to invest for income and keep up with inflation, especially outside of commodity-focused investments.

It takes an extra step to ferret out investments that will perform well while inflation stays high. We need higher interest rates.

But one category of income stocks offers the potential to grow your income stream even as the Federal Reserve tries to fight inflation by raising rates…

Since the prices of goods and services started to increase quickly last year, the Fed has been reluctant to raise interest rates. Remember when they thought inflation was “transitory?” The Fed was wrong, and now the only path to slow inflation will be for the Fed to jack up interest rates. Market pundits expect them to start increasing rates in March.

Look for the Fed Funds Rate to increase by 0.25% increments to reach somewhere between 2.0% and 2.5% by sometime in 2023.

Rising rates mean more interest expense for borrowers and higher interest income for lenders. However, most companies that make loans do so with borrowed funds, meaning they face higher income but also higher costs.

Companies like banks and finance REITs may see higher profits from higher interest rates, but they live on the interest rate spread, and that business model can run into challenges. These types of stocks are not a sure thing in a period of rising interest rates.

To invest for rising rates, dive into Business Development Companies (BDCs). The rules under which a BDC operates make them ideal for this period of time. Two factors give this category of financial company an edge.

First, BDC rules limit how much debt a company can issue. A BDC can have debt of more than two times equity; higher-quality BDCs keep debt at 1.0 to 1.5 times equity. As a result, a large portion of a BDC’s loan portfolio (loans made to clients) are backed by non-interest-bearing equity.

Second, on the lending side, BDCs put out loans that are almost 100% floating rate. As a result, as interest rates increase, BDC customer loan rates will also increase, and the majority of the gain in interest income will end up as net interest income (NII).

A BDC must pay out at least 90% of NII as dividends to investors by law. As a result, as interest rates go up, dividend rates will increase – as long as a BDC is well managed, at least. Lately, I have seen regular dividend increases out of the BDC sector and a number of the companies declaring added special bonus dividends.

With that said, here are a couple of my favorite BDC stocks:

Over the last year, Main Street Capital (MAIN) increased its regular monthly dividend twice, for a total increase of 4.9%. For the previous two quarters, MAIN declared supplemental dividends of $0.10 and $0.075, respectively. On the regular dividend rate, MAIN yields 5.25%.

In November, Hercules Capital (HTGC) increased its regular quarterly dividend by 3.1%, to $0.33 per share. In addition, Hercules paid supplemental dividends of $0.02 to $0.08 almost every quarter since the fourth quarter of 2018. For 2022, the company has already announced a $0.15 supplemental dividend to be paid every quarter this year. With the supplement, HTGC now yields more than 11%.With the power to perform well as interest rates increase, BDC share prices so far in 2022 have remained stable – a nice added factor as the broader market declines. It’s why I track several BDCs in my high-yield, low-risk income portfolio, The Dividend Hunter. Today is the best time in 22 years to get in – learn more here.

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