Why The Interest?


Q Why should equity investors pay attention to interest rates? I thought interest rates only affected bonds.
A Interest rates matter to equities for at least two reasons. First, they can alter the appeal of alternative investments. High rates on fixed-income investments reduce stocks' attractiveness, and vice versa. Second, high interest rates represent higher borrowing costs and greater interest expense for corporations, which can adversely impact earnings and, therefore, stock prices.

Q With interest rates microscopic, shouldn't stocks be skyrocketing?
A Many factors other than interest rates impact the stock market. Corporate profits and inflation affect stock prices over the long term, while a host of factors — such as political unrest or financial instability — can make a difference in the short term.

Q Could it be that "this time is different" when it comes to interest rates? Might investors' appetite for stocks forever decline even if bond yields stay unusually low?
A History warns us of the danger in assuming that "this time is different" with respect to a permanent change in investor behavior. However, history also shows that attitudes can swing in one direction for extended periods. Since the start of 2007, $1.18 trillion has flowed into bond funds versus $220 billion into stock funds. And in the 12 months ended April, $111 billion flowed out of stock funds while bond funds picked up $263 billion.

Investors have chosen bonds over stocks for two primary reasons. First, memories of 2008 remain fresh, and investors don't want to take another big hit to their portfolios. Their answer? To reduce or avoid exposure to stocks. For a sense of the level of risk aversion globally, consider recent debt auctions in Denmark and Switzerland. Buyers of sovereign debt accepted negative yields. In other words, investors effectively paid to lend money to those two countries.

Such risk aversion is probably not sustainable long term but could persist in the near term. Why? The answer lies in the second reason investors have pulled cash out of stocks to buy bonds — it has made them money.

The Barclays Capital Aggregate Bond Index, a popular bond benchmark, returned 75% over the last 10 calendar years and 28% over the last four. Bonds trounced the S&P 500 Index's 10-year return of 33% and negative return of 6% over the last four years.

Q What has to happen with interest rates to spur interest in stocks?
A Interestingly, stocks might actually benefit from higher interest rates. A rise in rates would crimp bond returns, giving investors second thoughts about their exposure to bonds versus stocks. How much would interest rates have to rise for bondholders to feel the pinch? Not very much. A return of the 10-year Treasury to its 20-year average yield of nearly 5% from its current level of 1.6% would gouge bond portfolios.

Q Will interest rates rise soon?
A With global economies seemingly slowing, the Federal Reserve Board doing what it can to keep rates down, and the U.S. credit markets still viewed as a "safe haven" for international investors, we don't expect rates to rise meaningfully in the short run. Of course, the stock market likes to turn the tables on consensus opinions; and if there was ever a consensus, it's the belief that minuscule interest rates are here to stay. Still, even a modest jump in interest rates would take a meaningful bite out of bond prices.

Q How should investors deal with interest rates?
A A number of stocks, such as tech giants Intel ($26; INTC) and Microsoft ($30; MSFT), offer attractive yields, good dividend growth, and decent capital-gains potential. They merit a look from investors who have too much exposure to bonds.

How much should you invest in bonds? One decent rule of thumb calls for subtracting your age from 110 to get a target percentage weighting for stocks, with the rest in bonds. Of course, this won't work for every investor. But it can help gauge whether your allocation tilts too heavily in one direction. When investing in bonds, diversify across investment-grade corporates, high yield, governments, and GNMAs, while biasing intermediate maturities. Forecasts recommendations include Vanguard Total Bond Market Index ($11; VBMFX), Fidelity High Income ($9; SPHIX), Vanguard GNMA ($11; VFIIX), and Vanguard Intermediate-Term Tax-Exempt ($14; VWITX).

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