What Stocks Do Best When Interest Rates Rise?


by Eric D. Nelson, CFA

Investors have contracted an irrational fear of rising interest rates, pulling a record $60B from bond mutual funds in June.  For those who have sold their longer-term and lower-quality funds, this probably makes sense, as these “reach for yield” strategies don’t provide the primary benefit of bonds—relatively low-risk returns designed to dampen volatility and panic-driven declines in the equity market.  For everyone else who has smartly avoided these excessively risky bonds and stuck with short and intermediate high-quality fixed income, rising rates shouldn’t have much effect on their balanced portfolios considering that even a modest rise in interest rates (and subsequent temporary decline in bond prices) is dwarfed by the much greater volatility in stocks.


But this does bring up the question, assuming you’ve already chosen the right types of bonds to appropriately reduce your portfolio’s risk...what stocks do best when interest rates rise?  Table 1 looks at all 12 month periods since 1928 when interest rates have risen (as measured by a negative “term premium”, or the return on 20YR Government Bonds minus the return on 1Mo Treasury Bills).


Table 1: Impact of Rising Interest Rates on US Stock Asset Classes (1928 to 5/2013)


% Average Return When Rates Rise

% Average Return for Total Period

20YR Gov't Bonds minus 1Mo T-Bills



CRSP 1-10 US Total Stock Index



US Large Value Stocks



US Small Cap Stocks



US Small Value Stocks



US “Balanced” Asset Class Mix



US “Value” Asset Class Mix



note: returns in chart are arithmetic and not geometric for comparability purposes

The first fact that stands out from the data is that stocks don’t necessary perform poorly when interest rates rise.  All major US equity asset classes had double digit returns, and results aren’t materially different than the average annual returns during the entire period.


Secondly, when rates do rise, we still see pronounced additional returns from value stocks and small cap stocks.  Compared to the +10.1% average return on the “market”, which is dominated by the largest and most growth oriented stocks, large value companies provided over 2% higher returns, small cap stocks almost 3% higher returns, and small value stocks almost 6% higher returns.  While all stock returns are 1-2% lower during periods when rates rise, the relative returns amongst asset classes are largely in line with the results over all periods since 1928.


Predictably, similar asset class returns produce similar asset class portfolio results.  Looking at the "US Balanced Asset Class Mix" and "US Value Asset Class Mix", we see returns of 3-4% more than the market index over the entire period as well as just the stretches where interest rates are rising. 


What to make of this data?  Admittedly, even when using short to intermediate-term high quality bonds, balanced portfolio returns could suffer a bit as interest rates rise and bond returns are below average for a stretch.  But by diversifying your stock portfolio meaningfully across smaller and more value oriented stocks, you position yourself for higher-than-market expected returns to help offset some of the potential underperformance in bonds.  Smaller and more value oriented stocks are expected to outperform the market over time, and evidence shows this effect hasn’t disappeared when interest rates are rising.  Along with the significant diversification benefits provided during periods when the large growth-dominated S&P 500 and total stock indexes disappoint, enlightened investors have yet another reason to embrace a more balanced and diversified asset class portfolio.



source: DFA Returns 2.0


US Large Value Stocks = DFA US Large Value Index

US Small Cap Stocks = DFA US Small Cap Index

US Small Value Stocks = DFA US Small Value Index

US "Balanced" Asset Class Mix = 30% S&P 500 Index, 30% DFA US Large Value Index, 40% DFA US Small Value Index; rebalanced annually.

US "Value" Asset Class Mix = 40% DFA US Large Value Index, 60% DFA US Small Value Index; rebalanced annually.


Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Clients’ investment returns would be reduced by the advisory fees and other expenses they would incur in the management of their accounts.  Past performance is not a guarantee of future results, and there is always the risk that an investor may lose money.  Indexes are not available for direct investment.