By Aye Soe
Rising interest rates certainly has become a central investment theme going into 2017. The 10-Year Treasury yield closed at 2.48% on January 27, 2017, representing an increase of nearly 103 bps from six months ago. Research has shown that equities tend to perform better following a rate hike, if inflation levels are moderate. However, return expectations on small-cap securities are mixed, as conventional wisdom dictates that small-cap securities require more capital, and therefore, higher borrowing costs for growth. It is therefore important to examine the potential performance behavior of small-cap indices in a rising rate environment.
To understand the sensitivity of small-cap securities to changes in interest rates, we performed a linear regression using the monthly returns of two headline small-cap indices - the S&P SmallCap 600 and the Russell 2000 - against monthly changes in the 10-Year U.S. Treasury rates. The regression equation is estimated on a rolling 36-month basis, and the average estimated beta coefficients for the two indices are shown in Exhibit 1.1
We can see that, on average, both small-cap indices have positive exposure to rate increases. In particular, the Russell 2000 exhibited slightly higher positive sensitivity to changes in rates. For every 1% positive change in 10-Year yield, the returns of S&P SmallCap 600 increase by 5.6%, on average, whereas the returns of Russell 2000 increase by 6%. However, the difference in coefficients (sensitivities) of the two indices is not statistically significant at the 95% confidence level.
Against that backdrop, we used observable returns of the two indices and interest rate changes to analyze further. We divided the test period into three interest rate regimes - decreasing, neutral, and increasing - based on rolling quarterly changes in 10-Year U.S. Treasury yields computed on a monthly basis, and we compared the average performance of the two small-cap indices during those periods (see Exhibit 2).
The data shows that during those periods in which the 10-Year U.S. Treasury yields rose by more 50 bps, both small-cap indices delivered returns north of 7% on average. Similarly, during those periods in which 10-Year yields remained neutral or rose less than 50 bps, both indices still delivered positive returns of 4% or more. Therefore, we can observe that neutral or rising rate environments can favor smaller-cap names. Conversely, during those periods in which yields decline by more than 50 bps, both small-cap indices posted negative returns, with the Russell 2000 losing more than the S&P SmallCap 600. The finding is not surprising, given that the Russell 2000 historically has higher sensitivity to rate changes than the S&P SmallCap 600.
Lastly, we went back and examined periods over the past 22 years2 during which the 10-Year U.S. Treasury yields rose meaningfully, defined as rate increases of 100 bps or more from trough to peak, and we computed the corresponding cumulative returns of the two small-cap indices as well as the S&P 500 (see Exhibit 3). The data supports that equities in both large-and small-cap segments stand to gain in rising rate environments. The data, however, refutes conventional wisdom that small-cap securities are disadvantaged by rate hikes. It is possible that there are macroeconomic and fundamental factors, such as economic growth and valuations, that are driving the performance of small-cap names during periods of rising rates. We intend to explore this deeper in a follow-up blog post.
Based on observable realized returns and yield changes, our analysis shows that small-cap securities outperform on an absolute basis as well as on a relative basis when compared to their large-cap counterparts.
Exhibit 3: Period Analysis of 10-Year Rate Changes and Performance of Broad Market Equity Indices
1 The equation is estimated as follows:
2 Based on the earliest available data for the two small-cap indices.