Interest Sensitive Stock

What Is Interest Sensitive Stock?

An interest sensitive stock is a stock that is especially influenced by changes in interest rates. Interest sensitive stocks including financial institutions, highly leveraged businesses, and companies that pay high dividends. An interest rate sensitive stock isn't intrinsically worse or better than a stock that is insulated against rate changes. Interest rate sensitivity simply means that the interest rate and interest rate projections become a key part of analyzing the stock as an investment.

Understanding Interest Sensitive Stock

In general, stocks tend to be sensitive to changes in interest rates, but some stocks are leveraged to interest rates because of their business model. For most stocks, low rates typically mean lower interest rate expenses on borrowed capital. This can result in higher levels of income as the cost of capital is lower overall. Low interest rates also affect valuations. Analysts use the risk-free rate when they determine the intrinsic value of a stock (with the rates on Treasury securities widely used as the risk-free rate). A lower risk-free rate typically translates into a higher intrinsic value.

Some stocks are especially sensitive to interest rates because of how their sector or business model operates. For example, utilities, REITs, and telecommunications companies often pay high dividends and are often bought for the income they generate for investors. For this reason, these stocks are often referred to as "bond substitutes." Just as bond prices decline when interest rates rise, so do these bond substitutes. When interest rates rise, investors shift out of these sectors on the belief that they can gain a similar level of income without the risk that stocks present.

Homebuilders may also see their share prices fall when interest rates rise. Rising interest rates mean higher mortgage rates, which can translate into fewer home purchases. Companies with large debt levels will also be very rate sensitive because their cost of borrowing is likely to rise. Highly leveraged companies already face an analysis discount depending on their debt-to-income ratio. In a rising interest rate environment, this discount increases.

Banks and financial institutions are, of course, also very sensitive to interest rates. Much of a bank's income comes from its net interest margin—the difference in the rate it pays on its bonds (and its account holders) and the rate it charges on the loans it makes. Because a bank typically borrows on a short-term basis and lends on a long-term basis, rising long-term rates typically boost the net interest margin, bank income, and, therefore, the price of its stock. This is a bit oversimplified as there are many other considerations when evaluating any stock, including banking stocks.