By: Dane Smith, Chris Carpentier and Christine Norton
Small caps underperform as yields rise due to higher financing costs and limited ability to refinance debt compared to large caps. While large caps locked in lower rates earlier, small caps may face refinancing at higher rates, affecting their bottom line.
The chart below illustrates moves of the 5 year yield compared to the relative returns of the Russell 2000 index vs the S&P 500, highlighting the relationship between small vs large cap equities and interest rates. An inverse relationship is evident – small cap stocks tend to underperform as yields rise. A little over a month ago the 5 year yield was around 4% and has since climbed to almost 4.6%. And during this time we’ve seen small caps lag.
Higher interest rates mean higher costs to finance operations. This affects small caps more for two reasons. First, since small caps are generally more risky, they already start with a higher cost of debt. Second, small caps are usually unable to refinance and lock in long term debt in the same way as large caps. For instance, some large caps were able to issue 10-year bonds a few years ago when rates were low, locking in this low cost over a long period. Many small caps, however, need to roll their debt over every 3–5 years, meaning they are closer to refinancing at current higher rates, which will directly affect their bottom line.
For 2025, while we do have a preference for US large caps, we also expect a rounding out of earnings to other sectors of the market. Should unemployment remain low and economic growth remain healthy, this may allow small caps to perform to higher expectations.
Originally published on January 20, 2025 on SSGA blog
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