Bank and resource dividends well placed for rising interest rates

Australian income investors will be partly insulated from the rising interest rate environment with dividend stalwarts in banking and mining set to benefit from or shrug off changes cash rate increases, analysts say.

Speaking with Morningstar, Jason Lye, a portfolio manager with First Sentier, says rising interest rates should lift margins and earnings for banks and insurers, adding fuel to the heavyweight financial sector’s ongoing post-pandemic dividend recovery.

Rate changes will have minimal immediate impact on the resources sector thanks to low debt levels and soaring commodity prices, he adds. The sector contributed the majority of ASX dividends in 2021, with iron ore giants BHP and Rio Tinto paying out 55% of all dividends alone.

“The banks have had years of falling rates punching their returns on equity and profitability, and that cycle is reversing again,” says Lye, who oversees the firm’s bronze-rated $560 million Australian Equities Growth Imputation Fund.

“Resources companies are probably the least exposed to that [rising rates],” he adds. “They have low debt levels. Compared to the profits they are making now, it’s [gearing] disproportionately low.”

Lye tips dividends in the financials and resources sectors to grow by 17% and 25% this financial year.

Morningstar forecasts paint a similar picture for Australian banks and miners. Banking analyst Nathan Zaia expects strong dividend growth over the next five years as a rising cash rate boosts bank margins. He forecasts interest margins rising by a minimum of 25% and for dividend growth to be “similarly strong”.

Dividend yields for the three major iron ore miners—Rio Tinto (ASX: RIO), BHP (ASX: BHP) and Fortescue (ASX: FMG)—are set to decline slightly but stay above 8.5% to June 2023, according to the latest Morningstar forecasts.

Pressure is growing on the Reserve Bank to raise the cash rate for the first time since 2010 as inflation hits record levels and central banks in the US, UK and New Zealand increase rates. Economists at UBS and AMP expect rates to reach 0.75% this year, with a first hike in June to 0.25%. Others say a May hike is possible.

The Reserve Bank has acknowledged a rate hike this year is “plausible”, while maintaining it intends to be patient and wait for underlying inflation to sustainably hit its 2% to 3% band.

Low debt levels

The most direct way for higher interest rates to cut into dividends is by increasing how much companies pay to service debt, says Lye. Higher interest payments leave less cash for dividends.

But debt is not an issue for the resources sector, says Lye. After watching expensive acquisitions and investments sour in the mid-2010s mining bust, miners are disciplined about spending and carry little debt. Soaring commodity prices are an additional buffer.

Net gearing ratios, which measure debt relative to company equity, were 10% or less for the major miners at the end of fiscal 2021.

Looking beyond next year, Lye says resources companies run the risk that a rising interest rate environment around the world crimps economic growth and lowers demand for commodities.

When it comes to banks, any costs associated with higher rates are more than offset by the expansion in margins, says Zaia. When the cash rate rises, the amount banks charge borrowers tends to increase faster than the cost of their own funding. Roughly a third of the money local banks lend comes from the almost-interest-free transaction accounts they offer customers.

“If you think about rates going up, that cost of funding stays at basically zero, and they're just charging more and more for their loans,” says Zaia.

Firms that carry lots of cash on their balance sheets also benefit from rising rates as the return to cash and cash equivalents improves, notes Lye. Insurers are one example, along with firms like Computershare (ASX: CPU), ASX (ASX: ASX) and EML (ASX: EML).

Caution advised in three sectors

Utilities, real-estate investment trusts (REITs) and industrials are three sectors where rising interest rates have the potential to materially hit earnings and dividends, with analysts cautioning investors to look for companies who have ways to insulate profits.

REITs operate with relatively high levels of debt, which can weigh on earnings as rising rates increase interest payments. Most trusts are well-hedged against rising rates, for now, however over the longer term it could become a headwind, says Amy Pham, a portfolio manager at the Pengana High Conviction Property Securities Fund.

“In times of uncertainty and rising interest rates and inflation, investors need to be selective,” she says. “Look for REITs that have pricing power.” She notes Goodman Group (ASX: GMG).

Morningstar forecasts narrow-moat Dexus (ASX: DXS) to have a dividend yield over 5% in fiscal 2023.

It is a similar story for certain utilities and industrial companies, notes Lye. Where debt burdens are high, rising rates will limit management’s ability to pay dividends.