Rising interest rates may hurt dividend-paying stocks, defensive sectors, and large caps more than their counterparts.
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.
- source: Morningstar Analysts
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.
- source: Morningstar Analysts