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How Rate Sensitive Are Your Equities?

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar.

The recent interest rate shock has concerned a lot of investors over their fixed-income holdings, but investors should also pay attention to how rising rates might affect their equity holdings as well. Here to offer some tips and insights is Morningstar's Christine Benz, our director of personal finance.

Thanks for being here, Christine.

Christine Benz: Jason, great to be here.

Stipp: When we're looking at the effect of interest rates on our portfolios, in some areas it's much easier to see the effect; in some areas it's less easy. The easiest place, you say, to see the effect of rising interest rates is really high-quality bonds or Treasuries.

Benz: That's right, and that's because the impact of rising rates is pretty easy to measure, pretty easy to see. If you have, say, a Treasury bond, it has no credit risk; all it has is that interest rate risk. So, it tends to be very responsive to interest rate changes.

With stocks, on the other hand, you see a lot more variation. They are responding to a lot more factors, including their own fundamentals--not just what's going on with rising interest rates and with the economy at large.

So, the impact isn't nearly so direct with stocks.

Stipp: Christine, when we're seeing a rising rate environment, what does that usually mean for companies, and hence for the stocks that we hold?

Benz: Well, oftentimes it means that the economy is growing at a really nice clip, and that is why interest rates are rising.

On the flip side, though, rates can rise too rapidly, and that can have a tendency to have a cooling effect on the economy. So, it's not necessarily always the same effect.

Stipp: What has the S&P done historically when we've seen these periods where rates are starting to tick up?

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Benz: What you see is that the S&P has generally delivered a positive return in periods of rising rates, just not as good as it has been in periods of declining rates. So, it's positive, just not as strong.

Stipp: Just like in fixed income, [where you see] certain kinds of bonds will react and be more sensitive to interest rates than other kinds--you also see some differentiation between how certain types of stocks perform when you see rising interest rates.

Benz: That's absolutely right. Any stock that someone is using as--or is likely to use as--a proxy instead of fixed-income holdings, those will tend to be the most vulnerable in periods of rising interest rates. In fact, we have seen that this past summer where we've seen utilities and real estate, in particular, get hit pretty hard during this period of rising rates. On the flip side, some growth stocks actually performed very, very well during this period, especially small- and mid-cap growth stocks.

Stipp: Is the idea that, as I can get more yield from bonds that are coming out now with higher interest rates, that looks relatively more attractive than having to take equity risk to get a dividend?

Benz: Exactly. That is the reason that some investors had been dumping utilities and REITs, because they do tend to have above-market dividend yields, which can be pretty attractive in periods when bond yields are as low as they had been until quite recently.

Stipp: In fact, we saw that investors were really quite interested in income for actually many months, even a few years, while interest rates were so low. So, it's quite possible you could have a tilt toward these dividend-payers in your portfolio, if you were on that hunt for income.

Benz: That's very true, and a lot of investors consciously want to have that tilt. They really like what dividend-payers bring to the table, and that's fine. I think that it's just important to recognize some of the interest-rate sensitivity that can come along with these types of holdings, especially anytime you're looking at dividend yields upwards of 4%. A lot of times those are the very securities that investors had been using instead of bonds. They may like bonds better now that yields are up a bit.

Stipp: If I'm looking at my portfolio, let's say I had tilted toward dividend-payers, and these do tend to be higher-quality companies, so it's not necessarily a bad decision. But I see underperformance now because of that. What should I think about my portfolio plan? What should be my next steps?

Benz: I think it comes down to balance, Jason. You do want to make sure that you have a diversified set of exposures in your portfolio on the bond side, as well as on the equity side.

On the equity side, I think it's fine to tilt toward dividend payers; often that means a tilt toward large-cap value stocks. They have generally performed better in periods when the equity market has been rocky. But I think you do want to make sure that you have exposure to other types of companies as well, to help offset some of this interest rate sensitivity that could well come home to roost over the next several years.

Stipp: So it comes back to the all-important diversification.

Benz: It does.

Stipp: All right, Christine, thanks for joining us and for those tips.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.