Jason Stipp: I'm Jason Stipp for Morningstar.
The recent rising-rate environment certainly took its toll on bonds, but how do stocks fare in a rising-interest-rate environment? Here to offer some great insights is Alex Bryan. He is a fund analyst on our passive investing team.
Thanks for being here, Alex.
Alex Bryan: Thanks for having me.
Stipp: You did a really interesting research report on Morningstar.com that looked at some of the trends, specifically [related to] stocks, in a rising-rate environment. But before we get to some of those, let's just refresh everyone on the difference between how stocks and bonds react when we start to see rates tick up.
Bryan: Fixed-income securities, or bonds, tend to be highly sensitive to changes in interest rates. And [with] bonds, most investors measure interest rate sensitivity by a measure called duration. Basically, bonds that have their cash flows further out in the future tend to be more sensitive to rising interest rates. That works in their favor, actually, when interest rates start to fall, but in a rising-rate environment, bonds that have their cash flows further out tend to do a little bit worse.
Now with stocks, it's different because cash flows are less certain with stocks than they are with bonds. Rates don't change in a vacuum, [and] in a rising rate environment, the economy is usually getting stronger in those times, and investors' expectations for stocks' future cash flows may rise as interest rates rise. So those rising cash flow [expectations] can offset the impact of rising interest rates, where bonds don't have that luxury.
So, usually … stocks that tend to be more volatile or more sensitive to the business cycle tend to do a better when you have a rising-rate environment.
Stipp: Of course, stocks are not a monolithic set. There are different types of stocks. And we know for a long time, interest rates were so low that investors were really looking for income anywhere else [than bonds], especially dividend-paying stocks.
…Let's say I'm one of those investors who went into dividend payers, because rates were so low. How did my dividend stocks perform during this period that we saw rates rise?
Bryan: Actually dividend-paying stocks have fared tremendously well, particularly in the last few years as interest rates have fallen. A couple of reasons for that: These companies tend to be higher-quality companies than your non-dividend payers, and when we have a really tough economic climate, as we have over the last five or six years, those types of companies tend to do better regardless of what their payout policy is. They just tend to be higher quality, more mature, better able to cushion the fall of a tough economic environment.
But these companies, because they tend to be more stable, they actually behave a little bit more like bonds than a smaller-cap or a more growth[-oriented] company would. So, their cash flows are more stable, and when interest rates are falling, they behave like long-duration bonds; they tend to do pretty well. And when interest rates start to go up, that may actually hurt them.
But that's not a reason to shy away from high-dividend-paying stocks. These stocks tend to be very high quality, and over a very long period of time, they've actually done quite well. Even though they may have a hard time over the next few years as interest rates start to rise, that is probably not a reason to dump them altogether.
Stipp: So, in some cases when we're seeing pressure on dividend payers, it's because investors … start to see higher yields on bonds now, and so some of the attractiveness of dividend payers because bond yields were so low starts to diminish, essentially, when rates start to rise.
Bryan: There has been a lot of talk about investors piling into higher-yielding asset classes--riskier bonds, higher-yielding stocks, REITs, things like that--and there has been some concern that this rotation to higher-yielding securities has pushed their valuations up and that really the inverse relationship between yields, or payments on these securities, and their sensitivity to interest rates is due to this valuation effect.
But this type of behavior where dividend-paying stocks tend to do better in a falling rate environment and do worse in a rising-rate environment, that's not just specific to dividend-paying stocks. Other stocks that tend to be more stable, they also tend to behave like that.
So, I looked at how utility companies fared in a rising-rate environment along with health-care stocks, telecom stocks, and looked across the sectors; the more defensive sectors tend to struggle in a rising-rate environment, specifically because their cash flows tend to be more stable.
So I thought that was a really an interesting find, and it shows that there is really a consistent pattern that we're seeing here. It's not specific to just the dividend-paying stocks.
Stipp: So, we're obviously in an environment now where rates have ticked up. We don't necessarily know where rates are going to go, but a lot of folks are saying they may continue to tick up at least to a certain amount. So, as I'm looking at my stock portfolio, what should I do given that some of these stocks, as you're mentioning, the more bond-like stocks, like these steady dividend-payers, could be under pressure. How should I think about my portfolio management there?
Bryan: There is no need to panic. Obviously rising rates are going to create a bit of a headwind both for bond investors and stock investors, but if you are really concerned about the impact of rising rates on your portfolio, there are a couple of things you can do.
One, this may be a good time to pare back on dividend-paying strategies. So I wouldn't dump dividend-paying stocks altogether, but if you have a large share of your portfolio in high-yielding stocks, this might be a good time to look at maybe bringing that weight back down toward a more reasonable, market-oriented level.
Secondly, if you're in a low-volatility strategy like the PowerShares S&P 500 Low Volatility fund, ticker SPLV, that tends to skew quite heavily toward defensive sectors like utilities and consumer defensive. There's another low-volatility strategy that may do a little bit better in a rising rate environment; it's the iShares MSCI USA Minimum Volatility fund, ticker USMV, which tends to anchor its sector weight, so it has a little bit less exposure to defensive stocks. That [ETF] still gives you a bit of the advantage of the low-volatility strategy, but with fewer defensive names in the mix. So that might do better.
And then the last thing you can do to try to cushion the impact of rising rates may be to tilt toward small-cap stocks, because small-cap stocks tend to be more sensitive to the business cycle. These companies are, for the most part, highly levered to the domestic economy. They don't have as much global exposure as a large company like GE or ExxonMobil. So, they actually have historically done better in a rising-rate environment. One way to get that exposure would be through Vanguard Small Cap ETF, and the ticker on that is VB.
So those are just some simple ideas that you can use in your portfolio, but again this isn't a time to panic. I wouldn't dump high-quality companies, because over the long haul they do well, and if you're looking at just cushioning the blow of rising rates, you have to also keep in mind that we can't predict the direction interest rates are going to go forever. They probably are going to go up, but even over a rising-rate environment over the long term, quality tends to do quite well.
Stipp: So, keep your eye on the fundamentals. Very interesting research on interest rates and stock movements. Thanks for joining us today and for those investment ideas as well.
Bryan: Thanks for having me.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.