By Alex Bryan
Fear of rising interest rates has a lot of investors on edge, to say the least. Clearly, rising interest rates are bad for bond and equity investors. It's easy to reduce interest-rate risk in a bond portfolio because interest-rate sensitivity, or duration, is directly related to the timing of cash flows. Bond investors can cushion the blow of rising rates by swapping out long for short duration bonds. But for investors who want to stick with stocks in a rising interest-rate environment, the options for reducing interest-rate risk are less clear. While some investment styles may help limit the damage the Fed can inflict on your portfolio, it's important not to lose sight of the big picture.
In a simple world where changes in interest rates (or associated changes in the strength of the economy) do not affect stocks' cash flows and where investors' risk tolerance is constant, low-growth dividend-paying stocks would be the least sensitive to changes in interest rates. These companies generate a larger portion of their total value from their near-term cash flows than their growth counterparts, which generate most of their value further out. Because interest is compounded over time, changing rates should have a bigger impact on the price that investors are willing to pay for a security as the time to realize its cash flows increases.
But interest rates don't change in a vacuum. They tend to rise when the economy is strengthening, which may increase investors' expectations of future cash flows. Investors may also demand less compensation for risk during these times. Both of these effects can partially offset the effect of rising rates. Conversely, falling rates may be associated with a weakening economy or a rise in the equity risk premium. Consequently, stocks' interest-rate sensitivity can differ from the timing of their cash flows, as the performance of dividend-paying stocks illustrates.
In a rising interest-rate environment, high-dividend-paying stocks have historically underperformed their lower-yielding and non-dividend-paying counterparts. The opposite is true when rates are falling or constant. In order to uncover that relationship, I looked at return data for non-dividend-paying stocks, dividend-paying stocks representing the 30% with the lowest yields, the middle 40%, and the 30% with the highest yields, from May 1953 through 2012. I ranked the monthly changes in the yield on the 10-year Treasury note and defined the quartile of months with the biggest jump in yields as periods of rising interest rates. The bottom quartile represents a falling-rate environment, while the middle 50% a constant rate environment. I then looked at how each of the four dividend portfolios would have performed in each of those three interest-rate environments. (This is not meant to illustrate an investment strategy, but rather how dividend-paying stocks tend to behave in different interest-rate environments). The table below shows the annualized returns for each portfolio.
I also ran a regression analysis on these portfolios' excess returns using the market risk premium and changes in the 10-year Treasury yield as explanatory variables. This approach allows us to control for fluctuations in the market and isolate how changing interest rates affect the performance of each portfolio. The coefficients from these regressions, presented in the table below, indicate how sensitive each portfolio is to both changes in the market and interest rates. A positive number indicates that the performance of the portfolio moves in the same direction as the corresponding variable, while a negative number indicates an inverse relationship. The farther these numbers are from zero, the stronger the relationship. For example, a market beta of 1 indicates that the portfolio increases 1% for each 1% increase in the value of the market. These results corroborate the findings above. Interestingly, non-dividend-paying stocks and low-yielding stocks tend to move in the same direction as interest rates (holding the market constant), while higher-yielding stocks tend to move in the opposite direction.
Conventional wisdom suggests that this inverse relationship between dividend yield and interest-rate sensitivity occurs because investors pile into higher-yielding (and often risker) assets when interest rates fall to make up for lost income. Conversely, when rates rise, investors move back into fixed-income assets. That may well be part of the story. There are certainly many retail investors (particularly retirees) who may follow this pattern to preserve investment income, but this group probably isn't big enough to fully explain this effect. Dividend-paying stocks tend to have more-stable cash flows than their non-dividend-paying counterparts. These companies wouldn't commit to regular dividend payments if they weren't confident in their ability to honor them throughout the business cycle. Consequently, their cash flows tend to be less sensitive to the health of economy, and interest rates, than non-dividend-paying stocks'. With less cash flow growth to offset the negative effect of rising interest rates, high-yielding stocks behave more like bonds than do their stingy peers and are more likely to suffer when rates rise. But their stable cash flow also works to their advantage when rates fall.
If this explanation is accurate, we should expect more defensive sectors to underperform in a rising-rate environment and outperform in a falling-rate environment. That's exactly the pattern we find. I ran the same regression as described above on several industry groups from May 1953 through 2012. The table below illustrates the results.
The health-care, tobacco, non-durable, telecom, financials, and utilities stocks moved in the opposite direction of interest rates. Demand for health care, tobacco, telecom, and utilities is non-cyclical. Many non-durable goods also experience relatively stable demand compared with purchases of durable goods, which consumers can more easily defer. Utilities were clearly the biggest losers when interest rates rose. This is because regulators often limit the prices they can charge and only adjust these rates with a lag after rising interest rates have eroded utilities' profitability. Unlike these defensive sectors, financial stocks' cash flows are closely tied to interest rates, but in contrast to other cyclical sectors, their cash flows may decline as rates rise. The cyclical durable goods, manufacturing, business equipment, and energy sectors tended to move in the same direction as interest rates.
I also ran this analysis on the S&P 500 sector indexes, from October 1989 through June 2013. The results from this sample are consistent with my findings for the longer period, though fewer of the relationships were significant. The defensive health-care, utilities, and consumer defensive sectors tended to underperform as rates rose and outperform as rates fell. The cyclical tech and materials sectors followed the opposite pattern. This evidence suggests that stocks whose cash flows are more sensitive to the strength of the economy tend to outperform in a rising-rate environment and underperform in a falling-rate environment.
That might explain why small-cap stocks were historically less sensitive to changing interest rates than their large-cap counterparts. The table below illustrates how small-, mid-, and large-cap stocks performed during periods of rising, falling, and constant interest rates, assuming perfect timing of each of those environments. Small caps fared better than their larger peers when rates were rising but underperformed as rates fell. The results of the regression analysis support these findings and suggest that small-cap stocks even move in the same direction as interest rates, while rising rates tend to hurt large-cap stocks. That makes sense because small-cap stocks tend to be more highly leveraged to the fortunes of the domestic economy than their larger counterparts. Interest rates tend to rise as the economy strengthens, which probably disproportionately helps small caps. They are also less well positioned to weather recessions than larger-cap stocks, which may explain why they tend to underperform as rates fall.
But just because you can reduce interest-rate risk by shifting away from dividend-paying stocks, defensive sectors, and large caps doesn't mean you should. These tend to represent quality companies that exhibit less volatility over the full market cycle. Low-volatility strategies might also underperform in a rising-rate environment because their cash flows don't rise as much as their peers' during economic expansions, providing a smaller offsetting effect to cushion the blow of rising interest rates. Yet, just as high-dividend-paying stocks have historically outperformed their non-dividend-paying counterparts, low-volatility stocks have historically offered better risk-adjusted returns over the full market cycle. Investors who load up on volatile, non-dividend-paying stocks may reduce short-term pain while interest rates rise but end up with disappointing long-term performance.
Moderation is a better approach. If you are concerned about rising rates, it may be worth considering paring back on high-dividend strategies, though it certainly isn't advisable to avoid dividend-paying stocks altogether. Nor is it necessary to flee from low-volatility strategies. However, if you own PowerShares S&P 500 Low Volatility (NYSE:SPLV), you might consider replacing it with iShares MSCI USA Minimum Volatility (BATS:USMV), which places a smaller bet on utilities and consumer defensive stocks. If you can stomach a little extra volatility, overweighting small caps may be a prudent move. Vanguard Small Cap ETF (NYSEARCA:VB) offers a cheap way to add a small-cap tilt. Me? I'm staying put.
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