Small-caps: A hedge for bond risk?

Written by: Global Thought Leadership | April 28, 2017

Source: Bloomberg, as of 3/31/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


The Bottom Line

  • Small-cap stocks might not be the first thing that leaps to mind when considering how to diversify a traditional stock/bond portfolio against rising interest rates.
  • Yet smaller company equities in general have had less correlation to investment-grade bonds than large-cap stocks—which suggests lower sensitivity to interest rates, a primary driver of bond prices. 
  • How to explain that relationship? Small-cap specialist Royce & Associates believes the main reason is that smaller companies in general are more directly tied to domestic growth than larger ones, which can receive substantial revenues from operations outside the U.S.
  • Since economic growth and rising interest rates often go hand in hand, small-caps may be well positioned to thrive in the months to come.
  • Consider the previous decade’s Fed interest rate tightening cycle, which saw the federal funds target rate rise from 1% to 5.25% between June 2004 and June 2006.1
  • During that time period, the Russell 2000 generated a two-year cumulative total return of 25.3%—versus 15.5% for the S&P 500, 5.76% for the Bloomberg Barclays U.S. Corporate Bond Index and 5.26% for Bloomberg Barclays U.S. Treasury Index.
  • The Russell 2000 Value Index—which tends to be more cyclically oriented than the broader Russell 2000—did even better, generating a two-year cumulative total return of 30.87%.
  • Of course, the past isn’t always a guide to the future.  But with the Fed hoping to move toward interest rate normalization, investors shouldn’t overlook the potential benefit of a small-cap allocation.
  • For additional insight on small-cap investing please see More Volatility Could Be Good For Small Caps and Natural Fit: Rate Hikes and Small-Cap Value.


1 Source for all data is Bloomberg.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Diversification does not guarantee a profit or protect against loss.

Outperformance does not imply positive results.

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.

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