Higher Rates Have These Top Stock Fund Managers Taking a More Defensive Stance

Key Takeaways

• Bond yields have risen to multiyear highs, and they could stay elevated for some time.
• Some portfolio managers are taking more-defensive positions in stocks and trimming artificial intelligence holdings.
• They’re avoiding companies with too much debt and adding exposure to dividend stocks, financials, and insurance.

Do higher bond yields demand a new playbook for stock investors?

The yield on the 10-year Treasury bond crossed 5% last week, and many investors believe that higher interest rates will stick around for the foreseeable future. While the move above 5% triggered headlines, the stock market has barely budged on the rise in rates. But some top stock fund managers say the likely higher-for-longer interest rate environment has them taking a more defensive posture.

The push higher in bond yields has been fueled by a potent combination of sticky inflation, strong economic growth, the ballooning US budget deficit, and a wave of debt sold to finance the booming artificial intelligence buildout.

Conventional wisdom among investors says that elevated yields, while a boon for income investors, are a headwind for the stock market. Higher borrowing costs eat into revenue and earnings. High interest rates can put downward pressure on valuations, too.

“We are at a little bit of a crossroads,” says Sebastien Mallet, manager of the $313 million T. Rowe Price Global Value Equity TRGVX, while the market juggles elevated rates and waits for massive capital investments in AI to bear fruit.

In the meantime, fund managers are looking toward more-defensive plays like financials, healthcare, and insurance. They remain focused on high-dividend payers, quality balance sheets, and firms without too much debt.

Playing Defense

Capital Group’s Hilda Applbaum, principal investment officer of the $150 billion American Funds Income Fund of America AMECX and a manager of the $284 billion American Funds American Balanced ABALX, says she’s not changing the mix of stocks and bonds in the portfolio sleeves she oversees. She is, however, changing the types of bonds and stocks she owns.

“I have become a little more defensive with the nature of the equities I hold, and more defensive in my bond holdings,” she says. That means shifting to higher-dividend-paying stocks like financials, which can earn more revenue from interest charges when rates are high. Higher rates are “oxygen to the financial sector,” adds T. Rowe Price’s Mallet.

Applbaum also likes pharmaceuticals, healthcare, and medical technology, industries that have been largely left behind by the AI trade. Mid- to high-single-digit growth plus a dividend rate of 2%, 3%, or even 4% “makes for a very attractive total return” in that sector, she says. Meanwhile, international markets provide a “very fertile fishing pond” for dividend stocks. Applbaum says she’s added to her international exposure over the past few years, within the limits of how much non-US stock her funds can hold.

T. Rowe’s Mallet is also tilting more defensive. He’s buying insurance stocks, which can invest customer premiums at higher yields when rates rise. He’s also bullish on commodities and is adding to oil-services stocks.

Applbaum says she’s also taking advantage of one silver lining of rising rates: 5% yields on cash. “It doesn’t feel terrible to hang out in cash for a little bit,” she says.

“It’s a little more palatable to carry cash in an environment where you can put it in money market [funds] and earn a return,” adds Nael Fakhry, a manager of the Osterweis Growth & Income OSTVX strategy.

Trimming AI Bets

After the eyewatering runup in AI stocks over the past year or two, some fund managers say now is the time to take profits. Mallet of T. Rowe Price says he’s trimming his bets, pointing to last year as his “best year ever” thanks to AI and semiconductor stocks.

Applbaum of Capital Group is also trimming her AI exposures around the margins as valuations have risen. “It doesn’t mean I’m not a believer in AI growth,” she says, though she notes that that growth might not be linear.

“Markets give you opportunities to trim and opportunities to add,” she says. “When everyone’s on one side of the ship, I find it not uncomfortable to at least go back to the middle of the ship—sometimes to the other side of the ship.”

Applbaum says she’s rotated into lesser-loved areas of the market using those proceeds.

Fakhry of Osterweis reminds investors that the revenue connected to the AI buildout may not last forever. As a result, “we’re trying to be very prudent around our allocation to the whole AI trade, and we want to own businesses that will do well regardless of how AI plays out.”

Avoid Overborrowers

Elevated interest rates make loans more expensive. That’s why Ian Sexsmith, a manager of the $2.3 billion Parnassus Mid Cap PARMX, is especially wary of highly leveraged companies. If rates stay elevated, companies with a lot of debt may have trouble refinancing. “That’s not going to be good,” he says.

Fakhry of Osterweis takes the same approach. “We don’t want to own a business with a stretched balance sheet, regardless of if it’s [an AI company] or not.” He says that better capitalized companies could actually stand to benefit from a higher rate environment. “They’re not trying to make it through the next quarter, they’re not in survival mode,” he says. That puts them at an advantage relative to their peers.

Treat Macro Bets With Caution

Even as high rates make headlines, fund managers warn against making investment decisions based on a top-down assessment of the economy.

“You’re going to be behind the curve,” says Sexsmith of Parnassus. He says he and his team are multiyear investors who select stocks using a bottom-up approach. “We’re careful when we buy stocks in the first place that they meet our definition of quality and are able to handle different environments,” he says. “We’re boring.”

Fakhry emphasizes that his team is not making investment decisions based on rate moves alone, but rather using a similar bottom-up approach to assess individual firms and industries. After trimming higher-valuation positions earlier this year, the team reinvested some of the gains in the financial and healthcare sectors.