The impact of interest rates on equities

For example, real estate investment trusts (REITs) seem to be among the most sensitive equities when rates rise or fall, but perhaps this is not a concern given their small weight in the TSX and lower weighting in core equity institutional equity portfolios.

As mentioned in the first article of this series, the following three steps can assist allocators in their examination of whether they have the appropriate equity exposure.

• Step 1: Examine the purpose of equities in the context of the portfolio (addressed in Part 1).
• Step 2: Look at whether the equity portfolio is accomplishing the goal set out in the initial exercise, especially as it pertains to interest rate exposure (addressed in Part 2).
• Step 3: Analyze the interest rate exposure in the equity portfolio and ensure that it is not skewed such that the downside risks are more significant than potential upside appreciation (addressed in this article).

The correlation between equity sectors and interest rates can change significantly over time. This can have major implications for a pension fund’s status, since certain assumptions are made regarding the ability to diversify across asset classes. During the past five years, the yield on the Government of Canada five-year bond has experienced periods of stability (late 2009 and late 2012), declines (mid-2011 through mid-2012) and increases (April to September 2013).

We looked at several scenarios of significant rate changes since the 2008/09 financial crisis to determine the relative performance of interest-sensitive sectors versus the S&P/TSX Composite. We chose to compare interest-sensitive sectors versus changes in the yield of the BofA Merrill Lynch 10+ Year Canada Corporate Index due to its comparability in terms of credit exposure.

Event #1 (April 30, 2009 to Oct. 31, 2010): Yields on the corporate bond index fell by a very significant 1.89% over this period. Note the very significant outperformance of all but the telecom sector in this environment. This period coincided with the equity market bottom after the financial crisis. REITs did well as they were coming off a lower base after being hit significantly in the 2008 decline. All financial sector stocks, including REITs, soared in 2009 and 2010. REITs were perceived to be low risk and rebounded after cutting payout rates in the crash. During the market rebound, they were able to access low interest rates to refinance and raise their payouts. Even with the economy growing slowly, REITs were able to consistently increase their cash flow. Dividend Aristocrats, pipelines, utilities and telecoms did not perform as well in this period given that they are more defensive. Generally speaking, this was a very predictable and successful outcome for interest-sensitive equities in this declining rate event.

Note: TSX return is absolute, sector returns are relative.
Source: Greystone Managed Investments

Event #2 (March 31, 2011 to Sept. 30, 2012): Yields fell 1.29%. In this period, every interest-sensitive sector dramatically outperformed the TSX by at least 15 percentage points, and the Dividend Aristocrats outperformed by 10.6 percentage points. Relating this back to articles No. 1 and No. 2, this is clear evidence that there are times when the index-relative performance of interest-sensitive equities is highly correlated with bonds. In this time period, the TSX index actually fell 8.2%, and, while rates were very low, investors were looking for defensive income.

Note: TSX return is absolute, sector returns are relative.
Source: Greystone Managed Investments

Event #3 (April 30, 2013 to Aug. 31, 2013): Yields rose 0.69%, and the TSX rose by 2.7%. All of the interest-sensitive sectors underperformed the TSX, with REITs being the worst at -20.6%. During this period, central bank “taper talk” dominated headlines, and investors worried about the reduced stimulus and its effect on markets. Defensive yield sectors such as REITs, utilities and telecom delivered very weak relative returns of -20.5%, -15.8% and -13%, respectively.

Note: TSX return is absolute, sector returns are relative.
Source: Greystone Managed Investments

In conclusion, the assumptions used with respect to asset mix can prove to be critical. When one delves into interest-sensitive sectors, the correlations to interest rates can become very significant. As a result, an equity portfolio with a heavy weighting to these sectors will not achieve the expected diversification benefits between equities and bonds. In the case of REITs, the relative underperformance was 20.5% in a 69 bps rate increase versus an average 31% outperformance for a much larger (-1.59%) decline in interest rates.

In terms of whether interest-sensitive equities have negatively skewed exposure to interest rates, consider the relatively modest 2013 rate increase (Event #3) versus the more significant rate declines experienced in Event #1 and #2. The 0.69% rate increase in 2013 compares to an average decline of -1.59% in Event #1 and #2, while REITs, telecom, and utilities experienced much larger index-relative declines in 2013 than might have been expected given their relative gains in 2009-10 and 2011-12.

In our analysis of these three recent examples, we have assumed that interest rates are the only factor impacting the values of these groups outside of the TSX. With that caveat, we can conclude that these select interest rate-sensitive groups did, in fact, experience a negative skew toward the downside when interest rates increased versus their relative upside rewards when rates decreased. Owners of these assets should maintain awareness of this sensitivity, especially since rates are expected to increase.