When it comes to interest rates, most investors think about bonds. But interest rates also play a large role in how investors value stocks, as well as affect the relative performance of equity sectors.
For certain sectors, a change in interest rates has a relatively large impact—and that impact has increased significantly in the “new normal” environment of low interest rates. With the sharp fall in interest rates over the past year, some of these sectors saw outsize differences in performance relative to the broader market.
The lowdown on rate-sensitive sectors
Let’s first talk about that group of interest-rate-sensitive sectors. The lineup includes a few of the traditional defensive sectors, such as Utilities, Consumer Staples and Health Care. Some pro-cyclical sectors, like Real Estate and Financials, also make the list.
For stocks, there is no simple equation that can measure the likely change in price for a given change in interest rates—many factors affect stocks’ sensitivity to rates, and that sensitivity can change over time. But we can run a regression analysis and get a pretty good idea how sectors have been affected over various time periods. Some of those factors for equity sectors include their dividend yield, debt ratios, and/or how their core operations are directly affected by interest rates.
- Financials: The Financials sector typically is highly sensitive to interest rates, as interest rates are often core to their operations. Higher interest rates usually translate into higher net interest margin—that is, the difference between the rate banks pay out on deposits and the rate they receive on loans. When the economy is bustling, interest rates usually rise at the same time loan demand is high. Because of this, there is typically a positive relationship between interest rates and relative performance of Financials compared with the broader stock market.
- Utilities, Consumer Staples and Health Care: High-dividend-paying sectors tend to perform well as investors seek their comparatively higher dividend yield during periods when interest rates are low. Also, those sectors that are capital-intensive and carry a high level of debt, such as the traditionally defensive Utilities, Consumer Staples and Health Care, benefit from lower borrowing costs as interest rates decline.
- Real Estate: Real Estate Investment Trusts (REITs), which make up the bulk of the Real Estate sector, are somewhat of a hybrid. REITs benefit from a growing economy, as property values, occupancy rates, and rental income all tend to rise in the good times. However, interest rates also tend to rise at the same time. Because REITs are big borrowers (in order to fund property purchases) and high-yielding (because they must pay out at least 90% of their taxable income to shareholders as dividends), higher interest rates exert downward pressure on relative performance. Typically, REITs exhibit an inverse relationship to interest rates, but there are times when the strength or weakness in the real estate market is dominant enough to offset the impact of interest rates.