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ETF Specialist

The Hidden Risk of Investing in Stable Companies

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

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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. 

Alex Bryan has a position in the following securities mentioned above: USMV. Find out about Morningstar’s editorial policies.