Small cap stocks have far less sensitivity to interest rate moves than their large-cap cousins -- a quality worth considering given the Fed's plans to normalize rates further this year.
There's a surprising aspect to small-cap stocks that many investors aren't aware of. And that's that it has lower interest rate sensitivity than large-caps. Actually, if you measure it, and you look at the correlation, small-cap stocks have roughly half the correlation to high-grade bonds that large-caps do.
You might wonder why that is? And there's a couple of reasons. There are higher yields in large-cap stocks, more dividend paying large-cap stocks.
But I think the largest reason is that small-caps are more attuned to the domestic economy, and they tend to be a little more cyclical than large-caps. When do interest rates rise in the U.S.? Well, generally when the economy is doing better. So, if interest rates are rising and the economy is doing better, that's an environment where domestically-oriented small-caps can do better as well.
What might happen if bonds decline?
Let's look at the last two calendar years where the bond asset class actually had a decline. Those were 2013 and 1999.
In both of those years, small-cap outperformed large-cap, actually pretty considerably. So, a rising interest rate, falling bond year, can actually be a pretty decent year for small-cap.
So, let's think about two different portfolios. The first portfolio doesn't have small-caps; say 60 percent large-cap, and 40 percent high-grade fixed income.
The second one has just 40 percent large-cap, 20 percent small-cap, and again, 40 percent high-grade fixed income. And let's see how they did in periods when interest rates rose, say by one percent or more.
What you find is, in most of those periods when interest rates were rising, the portfolio with small-cap outperformed. So, if you're looking to reduce your interest rate risk because you're concerned about rising rates, you might want to consider adding small-caps.