Interest rates have a powerful impact on security prices. As rates rise, the expected rate of return for all securities must increase to compete for investors’ money. This adjustment can be painful because it often requires prices to fall. Fixed-rate bonds are the most obvious example. Because their cash flows are fixed, the entire return adjustment must come from falling prices. Stocks are also affected by interest rates, but the impact is more difficult to anticipate because, unlike bonds, stocks do not have a finite life or fixed cash flows. However, their interest-rate sensitivity should be positively related to the stability of their cash flows. Consequently, low-volatility stocks should be highly sensitive to changing interest rates, as the remainder of this article will demonstrate.
Interest rates do not change in a vacuum. They tend to increase as the economy strengthens and central banks become concerned about inflation. Conversely, rates tend to fall when times are tough and demand weakens. Corporate profitability also fluctuates with the business cycle. Firms that are more sensitive to the business cycle tend to experience greater cash flow growth during economic expansions. As a result, they should do better when rates rise than their less-cyclical counterparts. But their cash flow also tends to contract more during economic downturns, when rates are most likely to fall, offsetting the benefit from lower rates. This suggests that stocks with more-stable cash flows should be more sensitive to interest rates.
Consistent with this theory, I published an article a few years ago showing that high-dividend-yielding stocks, stocks in more defensive industries, and large-cap stocks tended to be more sensitive to changes in interest rates than their lower-yielding, more cyclical, and smaller counterparts.1 To test the idea more directly, I extended this analysis to a few low-volatility indexes, including the S&P 500 Low Volatility and MSCI USA Minimum Volatility indexes.
The two indexes take very different approaches to mitigate volatility. The S&P index simply targets the least-volatile 100 members of the S&P 500 during the past 12 months and weights its holdings by the inverse of their volatility, so that the least-volatile stock receives the largest weighting. There are no constraints on its sector weightings, which often cause it to skew heavily toward interest-rate-sensitive utilities.
In contrast, MSCI uses a more complex optimization approach that considers both individual stock volatility and interactions among stocks to construct the least-volatile portfolio possible, under a set of constraints. Most notably, it limits its sector tilts relative to the broad large-cap market. These adjustments should make this index slightly less sensitive to interest rates than the S&P index because they tend to give it less exposure to defensive sectors.
Interest-Rate Sensitivity Analysis
To assess how these indexes performed in different interest-rate environments, I ranked the monthly changes in the 10-year U.S. Treasury yield from high to low from December 1990 through November 2016. The 25% of months with the largest positive interest-rate changes represented periods of rising rates. The bottom 25% represented the falling rate environment, while the middle 50% represented the constant rate environment. I then tracked each index’s annualized returns in the months corresponding to each of those three environments. Exhibit 1 shows the results.
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As expected, both low-volatility indexes tended to underperform the market, represented by the Dow Jones U.S. Total Stock Market Index, when rates were rising and to outperform when they fell. The magnitude of this under- and outperformance in the two environments was greater for the S&P 500 Low Volatility Index, likely because of its greater exposure to defensive sectors.
If low-volatility stocks tend to underperform when rates rise and outperform when they fall because they have smaller changes in cash flow to offset these changes in interest rates, high-volatility stocks should follow the opposite pattern. To test this, I included the S&P 500 High Beta Index in this analysis. This index targets the 100 stocks in the S&P 500 with the greatest sensitivity to market fluctuations (highest betas) during the past year. It then weights them in proportion to their market sensitivity so that the most-sensitive stocks receive the largest weightings. Consistent with expectations, this highly volatile index tended to outperform the market when rates rose and lag when they fell, as shown in Exhibit 1.
In Part 2 of this article, we will continue to look at low-volatility investing and use real-life examples for illustration.
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