Last week, yields on short-dated U.S. Treasuries quietly climbed to their highest point in almost 25 years.
The effects of that rise, however, have been anything but silent.
The average new mortgage rate now sits well over 7%; a home loan that would have cost $2,000 per month in 2021 would now set a new homebuyer back $5,660 monthly. And roughly 17% of all nonfinancial companies in the S&P 500 now spend at least a quarter of their operating income on servicing debts.
Though the United States has seen high interest rates before, we’ve never seen rates rise so quickly in relative terms. Moving from a 2.6% mortgage rate to a 7% one increases the portion going into interest payments almost threefold.
This will prove a disaster for many overleveraged firms (not to mention the U.S. government). Entities that were expecting to spend $100 million per year on interest payments now face the prospect of paying $200 million… $300 million… or more. Many private equity-backed firms like Bed Bath & Beyond (OTCMKTS:BBBYQ) have already folded; some are even worried about the U.S. government making good on its dues.
Yet, rising rates can also send shares of some companies soaring, provided you know where to look. High borrowing costs are a boon to lenders, underleveraged companies, and any firm where banks foreclose on competitors.
This week, the writers at InvestorPlace.com, our free news site, explore five companies that will thrive as rates continue to inch ever higher…
5 Stocks to Buy on a Potential Debt Avalanche: York Water (YORW)
High interest rates are a surprisingly good thing for water utilities, a sector with regulatory limits on profitability. Return on equity at these firms are usually capped between 9.5% and 10.5%. That means rising rates (i.e., higher borrowing costs) becomes an opportunity to raise prices.
Nowhere is this clearer than at York Water (NASDAQ:YORW), a Pennsylvania-based water utility with a 200-year track record of dividends. In the second quarter of 2023, York Water earned $18.7 million in revenues and paid out $1.68 million in interest, earning its shareholders $6.5 million in net profits.
Ordinarily, this would mark the upper limit to York Water’s profits. The company already earns slightly more than 10% returns on equity, limiting its ability to increase prices. But an increase in interest payments allows York to charge more for its services, which means higher future profits once rates fall again.
This week, InvestorPlace.com’s Rich Duprey also notes how York is a solid company with superior gross, operating, and net margins compared to virtually any other water utility.
“If you want a reliable, unstoppable dividend force of nature in your portfolio, York Water is certainly the one for you,” Duprey writes.
For investors seeking a dependable source of income while protecting themselves from rising rates, York Water is hard to beat.
2. Bank of America (BAC)
Traditional banks thrive on high interest rates. These establishments take customer deposits at near-zero interest and lend them out for profit. The higher the lending rate, the better the net interest margin.
Of course, the rise of alternative lenders has muddied the water. The failure of Silicon Valley Bank in March was initially sparked by investment losses from rising rates – the opposite of what banks usually face. Even blue-chip Charles Schwab (NYSE:SCHW) managed to get the formula wrong by overinvesting in rate-sensitive products.
But Bank of America (NYSE:BAC) has no such problem.
As Chris MacDonald notes this week at InvestorPlace.com, Bank of America has one of the sturdiest capital bases and best retail network of all American banks. Even Warren Buffett – a longtime critic of U.S. banks – is a shareholder.
MacDonald writes:
Warren Buffett continues to support Bank of America, holding a 13% stake worth over $32 billion. His endorsement and the retention of his shares, despite selling off other bank stocks, demonstrate his confidence in the bank’s strength and market position.
That’s because Bank of America has avoided the temptations that felled several regional banks this year. The company remains focused on its core business, and its large physical footprint gives the Charlotte, North Carolina-based bank an incredible supply of cheap capital (i.e., customer deposits) to keep thriving as rates stay high.
3. Realty Income (O)
“The Three Little Pigs” might as well be a story of cutting corners in real estate. (My contractor might learn a thing or two.) Some firms, like China Evergrande Group (OTCMKTS:EGRNF) , are built out of straw, with debts so high that even a slight breeze will send the whole thing tumbling down.
Others are built out of sticks, which look fine until a Big Bad Wolf comes along. Luxury-home builder WCI Communities generated $187 million of profits as late as 2005 before declaring bankruptcy during the financial crisis.
Then there’s Realty Income (NYSE:O), a solid house built out of bricks.
Realty Income, America’s largest triple-net real estate investment trust (REIT), has a 50-year history of distributing monthly payments. It also has increased its dividend for over 25 consecutive years, as Bob Ciura notes for InvestorPlace.com.
Here’s more from Cuira:
Realty Income generates its growth through growing rents at existing locations, via contracted rent increases or by leasing properties to new tenants at higher rates but also by acquiring new properties. In the first quarter, the company invested $1.7 billion in 339 properties and properties under development or expansion. The initial weighted average cash lease yield for these investments was 7%.
Triple-net leases are particularly desirable for investors, since these are long-term leases where tenants are responsible for all property expenses, such as real estate taxes and maintenance. This provides a dependable stream of income that can be funded by fixed-rate bonds, shielding investors from rate hikes.
Realty Income also focuses on defensive sectors, which has made the firm one of only two REITs to be a dividend aristocrat and have a credit rating of A- or better.
The stability, however, does come with costs. Realty Income typically caps annual rent increases to 1% to maintain long-term tenants, which limits growth. Extended periods of high interest rates will also slow the real estate market because acquisitions become more expensive.
Still, Realty Income remains one of the best REITs in the business for its conservative financing, A+ portfolio, and history of accretive acquisitions. If other REITs begin to wobble, Realty Income will be buying top-notch properties for pennies on the dollar for their investors.
4. Volkswagen (VWAGY)
This week, top InvestorPlace analyst Eric Fry notes how one company could dethrone Tesla as the king of EVs:
My top pick in the EV space is Volkswagen. …
While it’s true that Tesla’s EV sales crushed Volkswagen’s in 2022 by nearly 130% (with Tesla reporting 1.31 million EV sales in 2022 and Volkswagen reporting 572,100), Tesla trails far behind Volkswagen on all other relevant metrics. The differences between the two automakers are enormous.
I expect VW to continue outperforming Tesla in 2023 and beyond – by making a market-beating advance, as Tesla’s lavish valuation continues to shrivel.
Volkswagen AG (OTCMKTS:VWAGY) also has a more mundane tailwind: its ability to withstand high interest rates.
The German firm is one of the least leveraged legacy carmakers in the world. Its interest payments consume less than 7% of gross income. Its 49X interest coverage ratio puts it well ahead of Stellantis (NYSE:STLA) (23X), General Motors (NYSE:GM) (13X) and Ford Motor (NYSE:F) (8.7X). Only Toyota Motors (NYSE:TM) scores better, thanks to generous help from the Japanese banking system.
Volkswagen also generates a lot of cash for its market cap, giving it a significant advantage over “long duration” stocks like Tesla (NASDAQ:TSLA) whose success depends on profits further into the future. Rising rates make faraway cash flows worth less today, which increases the value of near-term cash flows in relative terms.
That gives the world’s largest automaker an astonishing amount of financial ammunition to grow its electric vehicle business. The EV revolution will be expensive, and Eric rightly points out that Volkswagen has the horsepower to make it work.
5. Amazon (AMZN)
Finally, InvestorPlace.com’s Jeremy Flint offers an alternative solution for investors worried about high interest rates:
They can outrun the problem with growth stocks.
That’s why Flint recommends Amazon.com (NASDAQ:AMZN) this week, a Magnificent 7 stock he calls a “no-brainer” buy.
Amazon’s commitment to cloud services and artificial intelligence positions it as a long-term, stable player in the sector. Cloud revenue surged by 12% in the most recent quarter, offsetting modest retail growth. Amazon’s cloud-based AI endeavors have broad applications that will serve the stock well.
Essentially, companies can sometimes grow so quickly that they overcome the downward pressure from rising discount rates. (As a reminder, discount rates and valuations move in opposite directions.)
Wall Street analysts now expect the tech giant to generate $28.3 billion in free cash flows this year, $46.9 billion in 2024, and $59.6 billion in 2025, a 45% average annual growth rate. With expansion that fast, another 1% to 2% increase in interest rates disappears to almost a rounding error.
Beware of a Debt Avalanche
It’s hard to overstate the impact of rapid rate rises. Earlier this week, shares of meme stock AMC Entertainment (NYSE:AMC) plummeted 40% after management announced it would attempt to convert roughly $400 million of debt into equity. These refinancing efforts become essential once a company’s cost of debt rises too high. Those that fail to manage debts will go bankrupt, as Rite Aid (NYSE:RAD) is preparing to do.
Even many financial companies are feeling the pinch. Since July, the KBW Nasdaq Bank Index has fallen 10% on fears of a corporate debt crisis. That’s the opposite of what should normally happen, because rising rates increase bank profitability, all else equal.
That tells us that a debt avalanche could happen. According to the Federal Reserve, nonfinancial corporations now owe $12.7 trillion in debt securities and loans, or 48% of GDP. That’s well above the 42% average seen between 1990 through 2020. Any misstep by the Fed could send a cascading debt crisis through the financial system.
It’s not surprising then that many investors are shifting away from the trend that worked in the first half of 2023 – investing in every AI stock out there – and becoming more selective.
Luke Lango has something new to help with that. Two years ago, he embarked on a groundbreaking project that – instead of investing in AI – uses artificial intelligence to pinpoint the moment a stock is about to surge in price.
Luke calls this new revolutionary AI program Prometheus, and he says it can give you the ultimate edge over the market.
And after two years of running 329,646 back tests, fine tuning, and millions of dollars invested, the results are in… and during his live event next Tuesday, September 12, at 7 pm Eastern, he’ll show us numerous examples of Prometheus’ accuracy and the fast gains it could deliver.
You can learn more about this AI program and sign up for Luke’s live event here.
As of this writing, Tom Yeung held a LONG position in GM. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.