Interest rates have a powerful impact on security prices. As rates rise, the expected rate of return for all securities must increase to compete for investors’ money. This adjustment can be painful because it often requires prices to fall. Fixed-rate bonds are the most obvious example. Because their cash flows are fixed, the entire return adjustment must come from falling prices. Stocks are also affected by interest rates, but the impact is more difficult to anticipate because, unlike bonds, stocks do not have a finite life or fixed cash flows. However, their interest-rate sensitivity should be positively related to the stability of their cash flows. Consequently, low-volatility stocks should be highly sensitive to changing interest rates, as the remainder of this article will demonstrate.

Interest rates do not change in a vacuum. They tend to increase as the economy strengthens and central banks become concerned about inflation. Conversely, rates tend to fall when times are tough and demand weakens. Corporate profitability also fluctuates with the business cycle. Firms that are more sensitive to the business cycle tend to experience greater cash flow growth during economic expansions. As a result, they should do better when rates rise than their less-cyclical counterparts. But their cash flow also tends to contract more during economic downturns, when rates are most likely to fall, offsetting the benefit from lower rates. This suggests that stocks with more-stable cash flows should be more sensitive to interest rates.

Consistent with this theory, I published an article a few years ago showing that high-dividend-yielding stocks, stocks in more defensive industries, and large-cap stocks tended to be more sensitive to changes in interest rates than their lower-yielding, more cyclical, and smaller counterparts.1 To test the idea more directly, I extended this analysis to a few low-volatility indexes, including the S&P 500 Low Volatility and MSCI USA Minimum Volatility indexes.