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This is how dividend-hungry investors can survive the onslaught of higher interest rates

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Income investors beware! You will need to adjust your dividend strategy in a market that is growing increasingly hostile to the yield trade!

The bond bear market may not have officially started but many dividend-dependent investors will need to have a radical rethink about their investment approach to stocks or risk nursing some serious losses.

This is because many of the most popular high-yielding stocks may be in for a long period of underperformance as bonds are sold off and bond yields rise (price and yield move in opposite directions) with global interest rates.

Stocks in the telecommunications, Australian real estate investment trusts (AREITs), utilities and infrastructure sectors typically form the core of an income-investor’s portfolio but these so-called “bond proxies” could be hit hard as they tend to be somewhat correlated to the bond market.

These stocks include the likes of Telstra Corporation Ltd (ASX: TLS), APA Group (ASX: APA), Sydney Airport Holdings Pty Ltd (ASX: SYD) and Scentre Group (ASX: SCG), just to name a few.

What normally drives these stocks is having a sustainable earnings stream that can cover the dividend payment. It doesn’t matter as much whether bond proxies have any real growth options.

But in a rising interest rate environment, the tables turn. It isn’t enough to have sustainable dividends as their yield advantage will slowly but surely erode. What is suddenly more important is the company’s ability to increase its dividend as rate rises.

The only way companies can lift their dividends is to grow earnings (or increase their debt, but that’s a big “no-no” in my book).

From that perspective, growth stocks with a half decent yield are the new best friends for income investors.

Don’t be too worried that these might only be on a current yield of a few percentage points. If they continue to grow their earnings, you will soon find that their dividend catches up pretty quick.

For instance, if you bought Paragon Care Ltd. (ASX: PGC) three years ago, the stock will be generating a yield of around 7.5% before franking, up from 3.5% when you first bought it.

Other stocks that have a bright earnings growth outlook that are well placed to be tomorrow’s high yielders include Altium Limited (ASX: ALU), AGL Energy Ltd (ASX: AGL) and Macquarie Group Ltd (ASX: MQG).

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Returns As of 6th October 2020

Motley Fool contributor Brendon Lau owns shares of AGL Energy Limited, Macquarie Group Limited, and Paragon Care Limited. The Motley Fool Australia owns shares of and has recommended Sydney Airport Holdings Limited and Telstra Limited. The Motley Fool Australia owns shares of Altium. The Motley Fool Australia has recommended Paragon Care Limited and Scentre Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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