To state that interest rates drive financial markets is to state the obvious. But defining the relationship between rates and mining stocks is a more difficult matter.
A new research report by CIBC World Markets analyst Jeff Evans entitled “Factor Focus: Interest Rate Sensitivity,” accomplishes just that.
While the report is not limited to mining stocks — Evans considers a broad array of securities from the TSX — he provides examples of mining stocks that help an investor leverage their interest-rate forecasting skills within the comfort of the mining sector.
The report was spurred on by the Bank of Canada’s recent announcement that it would hold rates at 1%, and that such low rates would likely remain appropriate for a “period of time.”
The bank’s signal to the market of stable low rates in the coming year set the table for the CIBC report.
In it, Evans outlines builing a long or short portfolio along three strategic lines to generate alpha.
The first strategy involves defining stocks by their sensitivity to short-term, three-month government rates. The second considers long-term government rates of 10 years, and the last looks at stocks that are sensitive to exposure to the Canadian dollar.
The report shows that exposure to short-rate sensitive securities is the way to go, as the portfolio built on such exposure generated consistent alpha over the sample period of 10 years, with limited volatility.
But to understand this conclusion, let’s examine the methodology.
A big step in putting together the strategy is calculating a stock’s sensitivity to interest rate changes using a rolling regression of daily interest rate changes versus stock prices.
The next step is building a portfolio that goes long securities with high interest rate sensitivity, while going short on stocks with low sensitivities.
The portfolio is intended to be market neutral, which means the betas of the individual stocks (the sensitivity of a given stock to the market) cancel each other out, leaving the portfolio with a total beta of zero. Ensuring market neutrality means that investors can rest assured that the resulting portfolio’s performance was almost entirely driven by the differences in interest rate sensitivity.
What jumps out about the first strategy is that despite the volatility in the short-term interest rate, the return on the market-neutral portfolio shows a relatively steady climb from 2004 up until this March. In other words, the volatility of the portfolio returns is far less than the volatility of the underlying rate.
Evans writes that since 2002 the strategy has generated an alpha of 4.9%, with 10.9% volatility. Most significant of all, the strategy performed well regardless of whether rates were rising, falling or stable.
It can do this under all three scenarios because the strategy adjusts the securities within the portfolio according to the rates. So when rates are stable it favours low volatility stocks, when rates are falling it prefers defensive stocks and when rates rise it rotates into cyclical stocks.
The report lists securities with high and low sensitivities under a stable, short-rate environment. Investors would have to calibrate sensitivities for themselves under different rate scenarios.
Mining stocks with high short-term rate sensitivities that are further well-rounded by scoring high on profitability and momentum characteristics include: Aurizon Mines (ARZ-T, AZK-N), Taseko Mines (TKO-T, TGB-N), Alamos Gold (AGI-T, AGI-N) and Sherritt International (S-T).
But this only represents one-half of the trade. To complete the portfolio the investor must also short stocks with low interest rate sensitivities. Some mining stocks listed by Evans that meet the criteria are: AuRico Gold (AUQ-T, AUQ-N), Lundin Mining (LUN-T), Osisko Mining (OSK-T), Centerra Gold (CG-T) and Alacer Gold (ASR-T).
The second strategy — choosing stocks based on sensitivities to 10-year government bond rates — doesn’t produce the same positive results as the short-term strategy, and it also comes with twice the volatility.
The strategy performed best when rates were rising from 2004 up until the collapse of 2008, when falling rates took returns on the long-term strategy along with them. But this positive correlation between returns on the portfolio and rates offers astute investors an opportunity.
Provided an investor has faith in their ability to forecast rates, building such a portfolio could do quite well in a rising rate environment.
The group of miners with high sensitivity to long-term rates that are candidates for the long side of the portfolio include: Rio Alto Mining (RIO-T), Nevsun Resources (NSU-T, NSU-N), Kinross Gold (K-T, KGC-N) and Agnico Eagle Mines (AEM-T, AEM-N).
Stocks with low long-term sensitivity that are good candidates for the short side include: Capstone Mining (CS-T), Teck Resources (TCK-T, TCK-N), Thompson Creek Metals (TCM-T, TC-N) and Hudbay Minerals (HBM-T, HBM-N).
The third strategy — the dollar-sensitivity strategy — is a reversal of sorts of the previous two, as it goes long firms with low sensitivities to the Canadian dollar and short stocks with high sensitivities. This means going long on domestic firms and selling importers and exporters.
Over the past 11 years, the strategy produced returns of 7.6% per year and was more effective when the Canadian dollar depreciated against the U.S. dollar. This theme has been strong in 2013, with investors favouring domestic-oriented firms in anticipation of the Canadian dollar depreciating further, Evans writes.
Miners that have low exposure to a depreciating Canadian dollar that should compose the long section of the portfolio include: Franco-Nevada (FNV-T, FNV-N), Agnico Eagle Mines and Rio Alto Mining.
On the short side, firms such as Lundin Mining, Turquoise Hill Resources (TRQ-T, TRQ-N) and First Quantum Minerals (FM-T) would fit the bill for good short candidates.
But if an investor believes that the Canadian dollar will appreciate, the best candidates for a long would be: Capstone Mining, Teck Resources and OceanaGold (OGC-T).
Under this appreciating scenario, good short candidates would be Barrick Gold (ABX-T, ABX-N), Yamana Gold (YRI-T, AUY-N), Semafo (SMF-T) and Eldorado Gold (ELD-T, EGO-N).