Investors have been debating about the prospect of an interest rate hike for quite some time now as many data points haven't really been definitive one way or another. But with the May jobs report, the interest rate hawks have some serious ammo, and increased rates seems just a matter of time now.
Not only did the total number of jobs created easily beat expectations, but average hourly wages soared too. The participation rate even moved off of its low, suggesting that people are being pulled back into the workforce too.
Interest rates have already been moving higher before this report, but following the release was no different. At time of writing, the 10-year Treasury bond rate is quickly approaching 2.5%, including a nearly 30 basis point move in the first week of June alone.
Stocks aren't exactly responding well to this news as the modest slump appears to be continuing for many securities. Indeed, the prospect of a rate hike appears to be scaring off many investors and pushing many bond investors to losses, a phenomenon that has been pretty rare in this recent bull run.
Why the Concern?
Higher interest rates can make stocks less appealing and especially so in the dividend space. Here, some risk adverse investors may be compelled to move to the fixed income world as rates rise, shunning high dividend paying stocks in the process.
Securities in capital-intensive segments-like telecoms -can also be hit by higher rates. These segments can have high levels of fixed income demands and increased rates will drive up their costs as well.
Higher interest rates could also draw in more foreign investors, and particularly from low yielding regions like Europe or Japan. An influx of capital would probably boost the dollar's prospects and this could impact commodity-linked investments as well, showing us that a number of segments can be tangentially impacted by a rising rate environment.
Is Everything Hurt?
Fortunately for investors, there are plenty of sectors and areas of the economy where a rate hike would actually be welcomed news. Corners of the market such as financials can benefit from a higher interest rate spread, consumers can see a boost if the dollar stays strong, while there are certain ways to play the bond market that could rise as rates ascend.
While most of these techniques can be played with individual stocks, an ETF approach can spread risk around in this uncertain time and could be a go-to choice for some investors. And with the proliferation of specialized ETFs there are now plenty of great ways to target portions of your portfolio to benefit from the inevitable rate hike.
So if you are concerned about the impact of higher rates on your portfolio, make sure to take a look at any of the four funds outlined below. They all stand to benefit from a higher interest rate environment and could easily help you navigate the coming storm in the bond market too:
Insurance stocks are one of the prime beneficiaries from a rate hike. That is because insurance firms must match up assets (bonds) with their liabilities (policies), so higher rates mean more investment income in their portfolios.
With more income and similar policy payouts, insurance companies stand to see their margins expand so they could be top picks in a rising rate environment. In fact, of the top 110 industries, three are insurance suggesting a pretty solid earnings estimate revision picture here.
There are a number of insurance ETFs, but let's take a closer look at the SPDR S&P Insurance ETF (NYSEARCA:KIE) today. This fund uses an equal weight methodology so no single stock will dominate the fund, giving broad exposure.
The fund is also a relatively cheap choice while it only puts about 20% of its assets in large caps, suggesting that a domestic focus will be inherent in this product. So if you are looking to get in on a safer play in a rising rate environment, it is hard to argue with an insurance pick like KIE for your portfolio.
Bank stocks also look to be winners in a rising rate environment, and we saw many of these stocks do quite well following the May jobs report. That is because as longer dated securities' rates rise, banks will have a wider spread between what they have to pay out on their deposits, and what they can get for mortgages.
This wider spread will make banks more profitable and increase the mortgage profits in particular for smaller regional and community banks. So in many ways, the banking industry looks to benefit much like the insurance industry by seeing the revenue from its assets (mortgages in this case) go up relative to the costs (bank deposit interest).
To play this space we can again look to SPDR and this time with their SPDR S&P Bank ETF (NYSEARCA:KBE). This is also an equal weight ETF so exposure is again going to be tilted towards small and mid cap securities. A focus like this will keep the fund zeroed-in on smaller banks which stand to benefit the most from a wider interest rate spread.
This fund charges investors 35 basis points a year in fees while it sees great volume approaching four million shares in an average session so tradability concerns should be minimal. Indeed, this appears to be one of the best banking choices to play higher rates while still getting a broad swath of exposure across the market capitalization spectrum.
Ex-Rate Sensitive ETF
For a different approach to the interest rate issue, PowerShares has recently come out with a pretty novel fund. Their product, the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSE:XRLV), focuses on the 100 stocks in the S&P 500 that have both low volatility and low interest rate risk.
This technique looks to include all of the stocks that have low volatility characteristics after removing securities that have historically been poor performers in a rising interest rate environment. We should also note that this is by no means a market cap weighted ETF as securities are weighted by the inverse of their volatility which gives the least volatile stocks the highest weights.
This results in a large cap centric portfolio with about 70% of the total holdings going to companies bigger than mid caps. It is also a relatively cheap choice as it costs investors just 25 basis points a year in fees for the exposure.
We should also note that it is a bit concentrated from a sector look as financials dominate here with a nearly 33% allocation. This is followed up by 19% to industrials, 14% to health, and 12% to consumer staples so it is still relatively diversified.
So if you are looking for a broad play that should be safe from rising rates, definitely consider XRLV. It shuns all the sectors and securities that will be hit hard in this environment, while it pretty much entirely removes company and industry specific risk as well. Just be mindful of wide bid ask spreads here as the fund hasn't experienced much popularity yet, though that could change if rates continue in this direction.
Negative Duration Bond ETF
A higher rate environment is going to be pretty brutal for bond investors, and especially those in the longer part of the curve. That is because as rates rise, bond prices necessarily fall which results in capital losses for those who do not hold bonds until maturity.
Fortunately, the ETF world has come up with a solution to this problem with the advent of negative duration bond ETFs. These products actually rise as bond prices fall thanks to some shorting of securities, though they still provide investors with fixed income like trading and a steady coupon payment.
Although this space is still pretty new, the WisdomTree Barclays U.S. Aggregate Bond Negative Duration ETF (NASDAQ:AGND) is a prime example of this budding trend. This fund has a duration of negative 4.6 years despite an average years to maturity of over 18 years.
The yield is nothing to write home about, but the security is focused on Treasury and Mortgage bonds so there isn't a ton of credit risk either. AGND also charges investors just 28 basis points a year in fees so it isn't expensive in the bond market for those seeking diversified exposure.
But if you are looking for a top choice in the bond world that will be relatively unaffected by rising rates, AGND will be tough to beat. The product has already started to outperform other bond funds as rates have risen, and we can expect this trend to likely continue as Treasury bond rates march higher.
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