It is beneficial to know what stocks are affected by different macroeconomic circumstances. This is so portfolios can be managed to take advantage of the change in environment. Last week we discussed defensive and cyclical stocks, this week we discuss interest rate sensitive sectors.
Interest rate sensitive stocks are stocks which react to interest rate movements more than the others in the market. A discounted cash flow is used to calculate a present value of the stock or to evaluate the intrinsic value. This formula uses the 10-year bond yield. So when this rate rises, the present day value increases. This makes the stock valuation more expensive. The stock market in general will look more expensive from this rise in bond yields, but this will affect higher yielding stocks more than others.
Examples of interest rate sensitive stocks
These stocks are seen as bond proxies which means they provide a steady form of dividend income – similar to bonds. Infrastructure stocks include toll road operations and airports. Once interest rates rise due to a stronger economy, then investing in infrastructure stocks will become less popular as investors rotate into growth stocks.
These stocks are usually considered defensive stocks and are bought for the income the stock may offer. They are interest rate sensitive as increases in interest rates will encourage investors to rotate out of this sector and into sectors which benefit from higher interest rates. A rise in interest rates affect higher yielding stocks more than others.
Utilities are interest rates sensitive as they are companies which usually have high debt ratios to finance for operations. When interest rates are low, the cost of borrowing is lower but when rates are hikes then interest expense costs are increased which may affect the company’s profitability.
These stocks are considered dependable businesses due to their consistent earnings. Telecommunication companies are also known to be stable dividend income payers. However, if interest rates rise due to economic growth, then investors will rotate out of defensive sectors such as telecommunications and into cyclical stocks.
Financial institutions are sensitive to interest rate movements. When interest rate rises, they can charge their clients higher rates which increases their net interest margins. Increased interest rates are a sign the economy is strong and demand from businesses requiring loans to expand may increase.
Lauren Hua is a private client adviser at Fairmont Equities.
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