Rates do not drive bonds alone

Putnam Investments, 03/08/17

Rates do not drive bonds alone

Since the election, the markets have pushed bond hyields higher in anticipation of stronger growth and higher rates. While trends like this cause investors to focus on fixed-income investments, it’s important to remember that stocks can also be sensitive to interest-rate risk.

Several equity sectors act like “bond proxies,” because they generate income, such as dividends. Yet investors may not be aware of research that has been done to quantify how these sectors may react when interest rates move.

One way to illustrate this sensitivity is by examining the level of volatility of these equity sectors, compared with Treasuries, in periods of rising rates.

The table below illustrates the sensitivity each of the 11 S&P industry sectors has had to stocks (S&P 500 ) and to interest rates (U.S. 7-10-year Treasuries) over the last 5 years using a two-factor model.

At the extremes, sectors such as real estate and utilities have calculated betas to the Treasuries benchmark ranging from +1.58 to +1.50, while financials and energy have had betas ranging from -0.97 to -0.43

Controlling for broad equity risk, the data indicates that investments in sectors such as real estate and utilities, have in fact, been more sensitive to a move in interest rates than 7- to 10-year U.S. Treasuries over the past 5 years. Real Estate for example, would be negatively impacted by an increase in interest rates, expected to move 1.58% for every 1% percentage change in the Barclays US Treasury 7-10 year total return index.

Financials in contrast, stand to benefit from a rise in interest rates, and would be expected to move -0.97% for every 1% change. Financials benefit in part because these companies may do more lending at higher interest rates, addingto their revenues.

To get a sense of what a move in yields could mean for the 11 S&P sectors given the differences in these sensitivities, the table below highlights the return impact that varying increases in yields (if in isolation) would have across the 11 S&P sectors.

A 1% increase in yields for example, would have an estimated impact of -12.0% and -11.4% respectively for real estate and utilities. In contrast, the financials sector would benefit by +7.4%.

Of course, many factors outside of interest rates that influence how various equity sectors perform. Yet the data suggests that changes in interest rates may carry a significant impact.

*Source: Putnam Investments. Multivariate 2-factor regression was run for each S&P 500 Sector Index over past 5 years as of Dec 2016, controlling for Equity (S&P 500) and Interest Rates (Barclays US Treasury 7-10 YR TR index).