Saturday, March 14, 2015

profiting from rising rates

Following another strong jobs report, the Federal Reserve is widely expected to drop the word "patient" from its monetary policy statement next Wednesday, signaling that a rate hike is likely coming soon. Whether it happens in June or September, higher interest rates appear to be finally coming.

Be prepared before that happens. Because by the time our central bank officially announces it is raising rates, many stocks will already have the move priced in.

There will be clear winners and losers during a rising interest rate environment. Investors looking to profit from a rate hike, or simply avoid significant underperformance, should consider shifting their portfolio now.

Rate Hike Losers
The Fed has stated if the economy continues to improve, rates will rise. After a stellar February jobs report blew away expectations, it's looking very likely that rates could rise sooner rather than later.

It's well known that a rising interest rate environment is bad for bonds overall, as their prices move opposite of rates. This is especially true for long duration, low coupon bonds. However, the impact on stocks will be much more mixed.

Some areas of the market are likely to suffer. Here are the areas I would avoid:

• High Yielders: As interest rates march higher, dividend yields will look comparatively less attractive to income investors than the yields on fixed income and money market accounts. Areas like real estate investment trusts (REITs) and utilities meet these criteria, as do Master Limited Partnerships (MLPs) and some stodgy consumers staples. The "reach for yield" trade that drove the valuations of many of these high yielders to record levels is likely coming to an end soon.

• Highly Leveraged Firms: Companies with highly leveraged balance sheets that rely heavily on debt financing are likely to underperform too. That's especially true for firms who are constantly issuing short-term debt to meet their obligations. Higher interest rates means higher interest expenses for these firms, and less profits. Once again, both real estate investment trusts (REITs) and utilities generally fit this description. It should come as no surprise that both areas significantly underperformed the S&P 500 during the second half of 2013 as long-term rates rose amid taper talks.

• Exporters: While our central bank is looking to raise interest rates, much of the rest of the world is trying to lower theirs. This could very likely lead to continued strength in the U.S. dollar, which would make our goods comparatively more expensive overseas. That would create a headwind for large multinational firms that derive a majority of their revenue from outside of the United States.

Rate Hike Winners
However, there are some industries that are clamoring for higher interest rates:

• Insurers: One particular beneficiary of higher rates is the insurance industry. Insurance companies take in premiums from customers, invest them - usually in fixed income securities like bonds - and then pay out claims in the future. Much of their profits are made on the interest income from their investments. When rates rise, they will be able to earn more interest from their investments. While it's true the value of their existing bond holdings would decline when rates rise, insurers with a relatively short duration on their investment portfolios should be relatively immune.

• Brokers: Other companies anxiously waiting for rates to rise are brokerage firms. Brokerages earn interest income on un-invested cash in customer accounts. So when rates rise, they can invest this cash at higher rates. While they will have to pay more interest on those cash balances, the spread between what they earn and what they pay out should widen from where it is today.

• Banks: Banks could also benefit from rising interest rates, as long as long-term rates move up more than short-term rates. Think about a bank's business model: they pay interest on deposits and loan that money out at higher rates. The interest rates on deposits are typically tied to short-term rates while loans are often tied to long-term rates. In other words, banks benefit from a steep yield curve, meaning when the spread between long-term and short-term rates is wide. So if the Fed hikes short-term rates, but long-term rates like the 10-year stay put, this will actually hurt net interest margins.

However, keep in mind that if the Fed raises rates, it will be because the economy is improving and inflation expectations are rising. Both of these conditions typically drive up long-term interest rates too, likely by more than the Fed raises short-term rates (usually in 25 basis point increments). Also, an improving economy means that credit quality is likely improving, which is great for banks' bottom lines as well.

Small cap banks should benefit the most from a steeper yield curve since a larger chunk of their profits come from interest income than large cap banks, which usually have more diversified revenue streams and are less susceptible to the yield curve.

The Bottom Line
If the U.S. economy continues to improve, then expect the Federal Reserve to finally increase interest rates from their rock-bottom levels relatively soon. Be prepared for the rate hike by shifting your portfolio now before it gets fully priced in. While some areas of the stock market are likely to underperform, others are well-positioned to profit. You should be too.

-- Todd Bunton, Weekend Wisdom

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