The Effect Of Rising Interest Rates


Anyone who's taken an introductory investments course probably knows high interest rates are bad for the economy and the stock market. Given that truism, it stands to reason that stocks would do better when rates are falling.

Since 1953 the S&P 500 Index has averaged a 12-month return of 6% when the yield on the 10-year Treasury note rose at least 0.5%, versus an average of 10% during periods when rates fell at least 0.5%. A logical, demonstrable trend — that seemed to end 20 years ago.

Since the end of 1994, the index averaged a return of 19% during 12-month periods of rising rates, while it declined an average of 1% when rates were falling. While problems with the data give us some caution about these numbers, it's tough to ignore the reversal of a decades-long trend — especially considering we're not the only ones to notice.

A 2013 study by Ned Davis Research found that from 1976 through 1993, stocks in all 10 market sectors tended to lose value during periods when the 10-year Treasury yield rose. However, from 1993 through 2013, only three sectors reacted negatively to rising interest rates, and the data wasn't statistically significant.

Will rates rise?

Two months ago, pretty much everyone expected interest rates to rise over the next year.

Things change.

Economic pressures overseas and at home have the Federal Reserve reconsidering plans to raise rates in the wake of December's 0.25% increase in the federal funds rate, the first hike since 2006.

Barring a substantial slowdown in U.S. economic growth, short-term rates should rise this year. Earlier this month, the 10-year Treasury note's yield fell to 1.63%, its lowest point in more than three years and a rate seen in just 0.4% of the days in the last 60 years. At today's levels, long-term rates would probably rise in response to pressure from short-term rates.

Inflation effects

Credit low inflation for at least part of the change. Inflation has averaged 2.0% over the last 10 years and 2.2% over the last 20, versus 4.2% for the previous 43 years. Inflation has historically been bad news for stocks, and yields often moved on inflation concerns. In addition, rising yields and rising inflation expectations tended to make rate hikes from the Federal Reserve a bigger threat.

Inflation has remained under control for most of the last two decades, leaving stock markets to worry more about the possibility of economic weakness. And yields tend to fall when expectations for the economy fade. 

One trend that has only intensified over the last 20 years is the sensitivity of stock prices to high interest rates. The S&P 500 Index is negatively correlated to interest rates, meaning the index has tended to be weaker when rates were high.

While researchers don't always find a strong link between stock prices and changes in interest rates, suggesting stocks may do just fine while yields rise, the picture gets uglier once interest rates rise — particularly for high-yield stocks.

Short-term interest rates remain at historically low levels. However, unless the U.S. economy weakens considerably, the Federal Reserve will probably raise rates at least once or twice this year. And with longer-term interest rates also at historically low levels, they'd probably have a tough time holding their ground in the face of a sustained rise in short-term rates.

High-yield stocks

Stocks with fat dividends could become less appealing as interest rates increase and investors can more easily generate yield using fixed-income securities. Investors often purchase these stocks more because of the yield than because they believe in the company's future growth and capital-appreciation potential. Not surprisingly, rising interest rates will sometimes drive investors out of high-yield stocks and into less-risky bonds, causing the stocks to lag.

We analyzed the returns of stocks in the S&P 1500 Index and found that since the end of 1994, those with yields below 1% substantially outperformed those with higher yields when interest rates were on the rise. 

A look at returns relative to absolute interest rates found the highest-yielding stocks substantially underperformed other stocks once the 10-year note's yield topped 6%. Interestingly, when interest rates were moderate, we saw little distinction between the returns of stocks in different yield bands.

Industry-specific research

According to TIAA-CREF, in the first 12 months of the last eight rate-tightening cycles, utilities and financials in the S&P 500 Index lagged the broad index at least 75% of the time. In contrast, industrials and other cyclicals tended to outperform.

Reams of research focuses on bank-stock returns relative to interest rates, with most (but not all) studies finding a negative relationship, meaning that when interest rates rise, bank stocks tend to lag the market.

A 2012 study in the Journal of Real Estate Financial Economics found that between 1992 and 2009, REITs averaged monthly returns of 1.17% during periods when the Federal Reserve is reducing rates versus 0.87% during rate-tightening cycles.

Not all studies drew the same conclusions, but most academic and industry research found utilities, banks, and REITs were not at their best during periods of rising rates. While we don't advise readers to avoid high-yield stocks altogether, it may be wise to temper expectations for them over the next year.

With interest rates likely to rise at least modestly in the year ahead, check out the table above. Those stocks should prove less sensitive to rising rates than the typical stock.

Alphabet ($732; GOOGL) and Foot Locker ($68; FL) have minimal long-term debt — no more than 5% of total capital — and business models that shouldn't be affected by higher interest rates. Alaska Air Group ($72; ALK) and Southwest Airlines ($39; LUV) carry moderate amounts of long-term debt (less than 30% of capital) and are expected to grow profits at an annual rate of at least 20% over the next five years.

On their own, higher interest rates should prove little hindrance to the operating results of the stocks in the table above. Of course, if the rise in interest rates dragged on economic growth, we'd be more concerned.

The stocks below satisfy four criteria designed to isolate those less sensitive to higher interest rates. Here are the criteria: long-term debt no higher than 30% of total capital, yield below 2%, and double-digit profit growth expected in the year ahead and annually over the next five years. Stocks on our buy lists are presented in bold.
Est. Profit Growth
Company (Price; Ticker)
LT Debt/
5 Years
($732; GOOGL)
Foot Locker ($68; FL)
Specialty retail
Cognizant Tech.
($57; CTSH)
IT services
Alaska Air Group
($72; ALK)
Southwest Airlines
($39; LUV)
Walgreens Boots
($78; WBA)
Drug retailing

Difficult analysis

Our analysis of 62 years of stock returns illustrates that since 1994, stocks have tended to rise along with interest rates, reversing a longstanding trend. While the trend seems clear, we don't trust the data as much as we'd like, for the following reasons:

Data confusion. A number of forces can cause bond yields to rise. Some of those catalysts will make stock investors expect a prolonged upswing and thus bail on dividend stocks, while others appear more transient. To eliminate most short-term fluctuations, we considered only periods when interest rates rose at least 0.5% over a 12-month period.

Anticipation. In a forward-looking market, stocks trade based on what investors expect will happen in the future. Some of the return periods we use won't reflect all of the anticipatory price action.

Limited observations. We considered more than 20 years of data, 242 rolling 12-month periods. While that sounds like a lot of observations, bond yields remained fairly steady for long stretches during that period.

Aggressive bear markets. During the declines from 2000 through 2002 and the financial crisis that started in 2008, stocks fell with unusual speed, in both cases during periods when rates also fell. The blend of falling prices and falling interest rates skewed data during the last 20 years, diverging from historical norms.

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