By Rodrigo Campos and Alison Griswold
NEW YORK (Reuters) - So much for higher interest rates taking a bite out of the stock market. Bond yields have risen sharply in the last two months, but the U.S. stock market has more than survived, with the S&P 500 and Dow industrials notching new all-time highs this week.
Rates are likely not finished climbing, however, and equity investors need to be prepared. Expectations that the Federal Reserve will soon start to pare its $85 billion a month bond purchasing program boosted the U.S. 10-year Treasury yield as high as 2.75 last week, climbing more than 110 basis points since May 1.
Corporations don't like to see borrowing costs rise, and the additional yield offered in fixed-income investments should draw back some of the risk-averse investors who have been digging for yield in the stock market.
But if the outlook for economic growth continues to improve, there are plenty of spots in the stock market that not only won't be hurt, but will benefit from rising yields.
"High interest rates generally are perceived as not great for the stock market. But if you go back in history, during the early stage of an interest rate rise, the stock market tends to do well," said Yu-Dee Chang, chief trader of ACE Investments in Vienna, Virginia. "I think that's the stage we're in."
Sectors that could benefit include regional banks, helped by higher long-term rates that improve lending margins. For the larger lenders the increase could be offset by write-downs in their bond holdings. Technology and smaller stocks that do well during periods of rising growth also are poised to outperform.
On the flip side, companies with higher debt levels dependent on borrowing may find their stocks languishing. There are two dozen S&P names, not including the financials and utilities, with debt levels exceeding 65 percent of their market value, and their borrowing costs would rise if they need to roll over debt issues.
Meanwhile, those companies whose appeal primarily stems from their status as a high-yielding alternative to bonds, such as utilities, have been hit since May as rates started to rise.
TECH STOCKS TO TAKE THE LEAD
In an environment of economic growth and rising rates, technology shares have historically outperformed all other sectors six months down the line, according to two separate analyses from JPMorgan and Birinyi Associates.
For example, the median move for the S&P semiconductors and chip equipment group is a gain of 37.8 percent six months after rates start rising, compared with a gain of 11.3 percent on the S&P 500, according to Birinyi.
Technology-focused funds have seen solid inflows in 2013, with more than $3.2 billion in inflows after two years of outflows, according to Lipper, a Thomson Reuters company.
A Morgan Stanley note showed technology and materials stocks are the best performers in a steepening yield environment, even when adjusting for the sectors' beta, or their volatility compared to the broader market.
A 50-basis point rise in benchmark yields, for instance, tends to produce about a 1.5 percent increase in tech. Materials rise about 1 percent, according to that data, and other sectors positively correlated with rising rates include "junk-rated" stocks and small caps.
Utilities, meanwhile, are hurt by higher rates, and would be expected to fall 4 percent in such a scenario.
BEWARE OF DIVIDEND PAYERS, HOUSING
Stocks that have fallen amid expectations of higher rates include those that have a high percentage of debt when compared with their market value. The concern is that those that frequently sell debt will incur higher costs as rates rise.
"You want companies with strong finances, first of all, so they won't have to incur higher interest charges as they borrow," said John Carey, portfolio manager at Pioneer Investment Management in Boston, which oversees about $200 billion in assets globally.
Not including financials and utilities, both sectors that count on borrowing heavily for their operations, the average S&P 500 figure on long-term debt as a percentage of market value was 15.9 percent as of the end of the first quarter.
More than 20 non-financial or utilities companies have a ratio of more than 65 percent, including Iron Mountain Inc
Dividend payers have also trailed the S&P, if only modestly. Those who invest for income often look at the S&P 500's dividend yield - a measure of the dividend returns divided by the index price - against the 10-year note as a yardstick.
The S&P dividend aristocrats index <.SPDAUDP>, which includes only S&P 1500 components that have increased their dividend every year for at least 20 years, rose nearly 19 percent from its close last year to May 21, compared with a 17 percent gain on the S&P 1500.
Since then, however, it has slightly underperformed. The S&P 1500 is now up 1.1 percent from that previous record closing high, while the "aristocrats" have gained less than 0.1 percent.
"We've already seen some of the negative reaction with what the market was euphemistically referring to as 'bond proxies,'" said David Joy, chief market strategist at Ameriprise Financial in Boston, where he helps oversee $708 billion in assets.
Since May 21, the S&P utilities sector <.SPLRCU> is down 2.3 percent. Telecoms <.SPLRCL> are 3.1 percent lower from that date. Funds specific to utilities have seen three consecutive weeks of outflows, according to Lipper, and the four-week moving average of outflows is currently $240 million, representing the heaviest flight from those funds since September 2007.
(Reporting by Alison Griswold and Rodrigo Campos, additional reporting by Richard Leong and Jonathan Spicer; Editing by David Gaffen and Claudia Parsons)