Talking Points: Rising Rates

Morningstar's mutual fund analysts share what they're hearing from fund managers.

The Issues
Stocks may be better off than bonds when interest rates rise, but by how much is hard to say. To stay competitive if bond yields rise far enough, stocks may have to reset their valuations lower to increase their prospective long-term returns. Rising interest expenses also could clip corporate profits, says Jamie Farnham, director of credit risk at TCW/MetWest.

How rates rise matters, too. High valuations at the start of a rate-tightening cycle can make stocks more sensitive to hikes. Sharp, unexpected spikes in inflation and interest rates, which often coincide, increase the odds of lousy equity returns, but there's still a wide range of possibilities, says Fran Kinniry, an investment strategist with Vanguard.

Gradual rate increases might be easier to take and even be welcome, especially if they come because of economic growth. Indeed, some businesses are counting on higher rates to help them. Charles Schwab SCHW, for example, gave up $125 million in 2010's first quarter alone on money market fee waivers.

Higher rates will affect stocks in unpredictable ways. Trying to evade those effects could cost you, though. A recent Standard & Poor's study found that S&P 500 stocks rose an average of 7.3% in the year after the start of 13 Fed-tightening cycles since 1946.

Points
* Many investors use equity duration to measure stocks' interest-rate sensitivity. In general, as the equity market's dividend and free cash-flow yields rise, its duration decreases, and vice versa. Growth stocks, which often don't pay dividends and have lower free cash-flow yields, tend to have longer durations and to be more interest-rate sensitive than value stocks, says Robert Hagstrom, manager of Legg Mason Management Growth LGGAX. Having a portfolio with a higher average free cash-flow yield relative to your peers and benchmark could help when the hikes happen.

* Valuations matter, too. As John Hussman pointed out nearly three years ago, "When valuations are cheap and risk premiums are wide, falling interest rates contribute to downward pressure on risk premiums and upward pressure on stock prices. . In contrast, when valuations are high and risk premiums are already thin, rising interest rates contribute to upward pressure on risk premiums and downward pressure on stock prices."

* It's the ones you don't see that you have to worry about. Stocks on average have lost 2.3% when inflation and interest rates rose unexpectedly, according to a Vanguard study. But the range of results is wide, including a period with a 53% gain, Vanguard's Fran Kinniry says. So it's not a slam-dunk that stocks are going to do poorly. "One huge caveat to all this is that stocks are such a wild-card asset class," he says.