With Rising Interest Rates Looming, Should Income Investors Dump National Grid plc In Favour Of HSBC Holdings plc?

National Grid (LSE: NG) (NYSE: NGG.US) and HSBC Holdings (LSE: HSBA) (NYSE: HSBC.US) are both considered FTSE 100 dividend heavyweights. However, with interest rates set to begin creeping higher in the near future, I feel that National Grid’s dividend payout could come under pressure.  

national gridNational Grid is in a bad position

Unfortunately, thanks to its high debt pile, National Grid is extremely exposed to rising interest rates. In particular, at the end of 2013 National Grid had net debt of around £26bn and throughout the year the company paid £850m to finance this debt, which implies that the company’s interest rate is currently 3.3%.

However, if the Bank of England was to increase the base rate by 1%, it is likely that National Grid’s interest costs would also rise by 1%, implying that the bank would have to pay 4.3%, or £1.2bn in interest per year. Further, if the Bank of England increased interest rates by 2%, National Grid’s interest costs would rise to 5.3%, or £1.4bn. This 2% interest rate increase would cut National Grid’s net income by 22%.

Unfortunately, it is likely that a 22% reduction in net income would call into question the sustainability of National Grid’s dividend payout. Specifically, based on 2013 numbers, National Grid’s dividend payout was only covered 1.2 times by earnings showing that the company does not have much room for maneuver.

Banks are better positioned

With National Grid’s payout under pressure as interest rates rise, HSBC’s payout appears to be much safer, as the bank is able to hedge interest rate movements.

You see, HSBC relies upon the net interest margin to generate the majority of its profit. The net interest margin is simply the difference between the interest rate that the bank charges customers to borrow and the rate of interest the bank pays out on savings accounts.

As a result, if interest rates go up, HSBC can increase the interest rate it charges customers to borrow, while increasing the rate it pays to savers, keeping the net interest margin constant. Effectively, HSBC is somewhat immune to rising interest rates.

Further, based on numbers for full-year 2013, HSBC’s free cash flow is more than enough to cover the banks dividend payout several times over, which has risen to speculation from City analysts that HSBC could return even more cash to investors. Based on earnings HSBC’s 2013 dividend yield of 5.3% was covered 1.8 times by earnings per share.

Foolish summary

So overall, as interest rates rise National Grid is going to have to payout more to finance its colossal debt pile, which will dent net income and put the company’s dividend payout under pressure. In comparison, HSBC is able to navigate around rising interest rates, making the company’s dividend payout look more secure than that of National Grid.

Still, if you're not convinced that HSBC is a better choice than National Grid but want further advice on how to invest for income, analysts here at the Motley Fool have put together this free report entitled, "How To Create Dividends For Life".

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Rupert does not own any share mentioned within this article.