Rising Rates May Hurt Small-Cap Biotech ETF Valuations

The Federal Reserve has hiked interest rates for the second time in a decade and plans to raise rates three more times next year. With higher interest rates, investors may find small-cap biotechnology exchange traded funds that track companies banking on a breakthrough drug less appealing.

While few development-stage companies fund their operations with debt and large pharmaceutical companies have strong balances, rising rates are problematic for smaller biotech companies that have unprofitable operations and can only appeal to investors as a big theoretical payoff, writes Charley Grant for the Wall Street Journal.

These small biotech companies are still working on federally approved drugs and payoffs can be several years down the road if the drug is still stuck in early-stage clinical trials. Consequently, discounting that payout with a higher interest rate translates to a lower value of that payoff today.

Investors can think of these small-cap biotech stocks’ situation as a common debt loan. Grant calculated that a payoff of $1 million five years from now is worth $680,000 today discounted at an 8% interest rate, but if rates rise to 10%, the present value of the future payoff dips to $620,000.

So without a steady revenue stream, these developing biotech companies are essentially banking on their future payouts, and in a rising rate environment, the calculated current value of these payouts are lowered.