As the UK economy is rapidly improving, it’s now widely believed the Bank of England will begin to raise interest rates at some point over the next 12 months.
This will be great news for savers, who have been struggling with rock-bottom interest rates since the financial crisis. However, for investors, rising interest rates could bring about some unwanted consequences.
You see, according to financial data company Morningstar, over the past few decades a trend has developed between the price movements of defensive companies and interest rates.
It has been found that these defensive companies act a lot like bonds, which rise in price when rates fall, but fall in price when interest rates go up. Simply put, the rush of investors searching for yield pushes the price of defensive shares up and the yield down.
Unsurprisingly, Morningstar also found that the share prices of cyclical companies will rise when interest rates increase as this signals an improving economic climate.
Impressive run
National Grid (LSE: NG), SSE (LSE: SSE), Centrica (LSE: CNA), United Utilities (LSE: UU) and Severn Trent (LSE: SVT) are some of the market’s most defensive companies and they have all seen their share prices sky-rocket over the past five years, thanks to the hunt for yield.
For example, since 2009 National Grid, SSE, United Utilities and Severn Trent have outperformed the FTSE 100 by 28%, 13%, 60% and 78% respectively.
Unfortunately, these gains have driven the shares in question to record high valuations, which appear unsustainable, especially as interest rates are about to start rising. Indeed, National Grid currently trades at a forward P/E of 16, compared to a five-year historic average of 12.1. The company currently supports a dividend yield of 4.8%, compared to its five-year average of 6%.
Despite political concerns, SSE currently trades at a forward P/E of 12.9 and supports a yield of 5.7%, compared to a five-year average P/E and yield of 11.5 and 6% respectively
Set to fall
After these gains, there’s reason to believe that National Grid, SSE, Centrica, United Utilities and Severn Trent are all set to fall as interest rates rise and investors sell up and move their cash elsewhere. The sell-off is likely to be exasperated in companies like United Utilities and Severn Trent, which have both jumped to record valuations following bid speculation.
United Utilities and Severn Trent currently trade at a forward P/E of 18.1 and 21.7 respectively, compared to five-year averages of around 16. The two water service providers also used to support dividend yields in excess of 6%, far above the yields of around 4.5% currently on offer.
On the other hand, thanks to political interfering and concerns over the company’s growth plans, Centrica now looks to be appropriately priced at current levels. Specifically, the company is currently trading at a historic P/E of 11.1, compared to a five-year average of 12.6. Additionally, the company currently supports a dividend yield of 5.8%, compared to the average of 4.8% over the past five years.
