The Federal Reserve approach to fight skyrocketing inflation has raised the prospect of rate hikes this year, pushing the yields higher. The increase in interest rates will make borrowing expensive, driving up the cost of buying a new car or house, or carrying credit card debt and thus slowdown economic growth.
In this backdrop, investors should be well prepared to protect themselves from higher rates. While there are number of ways that could prove extremely beneficial in a rising rate environment, ETFs like SPDR S&P Insurance ETF ( KIE Quick Quote KIE - Free Report) , SPDR S&P Regional Banking ETF ( KRE Quick Quote KRE - Free Report) , Vanguard Value ETF ( VTV Quick Quote VTV - Free Report) , JPMorgan Ultra-Short Income ETF ( JPST Quick Quote JPST - Free Report) and iShares Floating Rate Bond ETF ( FLOT Quick Quote FLOT - Free Report) from different corners of the market seem compelling picks. Rate Hike in Cards!
In the latest FOMC meeting, Fed Chair Jerome Powell, stated that "the economy no longer needs sustained high levels of monetary policy support," and that "it will soon be appropriate to raise rates for the first time in more than three years.” The consumer price index jumped 7% year over year in 2021, the largest 12-month gain since June 1982. The red-hot inflation has set the stage for the first interest rate hike as soon as in March (read:
ETFs to Buy on Likely March Rate Hike And More Thereafter). Wall Street analysts are predicting as many as seven rate hikes this year. Goldman Sachs sees five rate hikes, versus four previously, with the first increase in March while Bank of America projects seven rate hikes this year. According to the CME FedWatch tool, the market is pricing in five interest rate hikes for 2022, with a sixth one starting to gain traction for later in the year. However, higher interest rates indicate investors’ optimism in the economy. A still-improving economy backed by job growth and higher consumer confidence will likely bolster risk-on trade. The U.S. economy expanded 5.7% annually in 2021, marking the fastest pace of growth since 1984 and a sharp reversal from the GDP contraction of 3.4% recorded in 2020. Any Reason to Worry?
The initial phase of increase will actually be good for stocks as it will reflect an improving economy. Plus, higher rates would attract more capital to the country, thereby boosting the U.S. dollar against the basket of other currencies. However, since a strong dollar should have a huge impact on commodity-linked investments, a rising rate environment will also hurt a number of segments.
In particular, high dividend paying sectors such as utilities and real estate would be the worst hit given their higher sensitivity to rising interest rates. Further, securities in capital-intensive sectors like telecom would also be impacted by higher rates (read: 10 Dividend ETFs Up At Least 4% This Year & Yielding At Least 3%). Insurance
Insurance stocks are one of the prime beneficiaries of a rate hike, as these are able to earn higher returns on their investment portfolio of longer-duration bonds. But at the same time, these firms incur loss as the value of longer-duration bonds goes down with rising interest rates. Nevertheless, since insurance companies have long-term investment horizons, they can hold investments until maturity and hence, no actual losses will be realized.
SPDR S&P Insurance ETF follows the S&P Insurance Select Industry Index, holding 53 stocks in its basket, with each firm accounting for no more than 2.4% share. About 45.8% of the portfolio is allocated to property and casualty insurance, while life & health insurance and insurance brokers round off the next two spots with double-digit exposure. SPDR S&P Insurance ETF has managed $429.8 million in its asset base and trades in a good average daily volume of about 855,000 shares. The product has an expense ratio of 0.35%, a Zacks Rank #3 (Hold) and a Medium risk outlook. Banks
As banks seek to borrow money at short-term rates and lend at long-term rates, the rise in interest rates will earn more on lending and pay less on deposits, leading to a wider spread. This will expand net margins and increase banks’ profits. The current near-zero rates have dampened net interest margins (an important barometer to gauge banks’ financial performance), thereby hurting banks’ top-line growth. When the Fed starts increasing interest rates, pressure on margins will gradually alleviate and support banks’ net interest income. Notably, banks earn a major portion of their revenues from interest income.
SPDR S&P Regional Banking ETF provides exposure to the regional banks’ segment by tracking the S&P Regional Banks Select Industry Index. It holds 138 stocks in its basket with each accounting for no more than 2.2% of the assets. SPDR S&P Regional Banking ETF has AUM of $429.8 million and charges 35 bps in annual fees. It trades in an average daily volume of 11.3 million shares and has a Zacks ETF Rank #2 (Buy) with a High risk outlook (read: Count on Bank ETFs as Rates Rise). Value
Higher yields suggest improving economic activities and will thus result in increased industrial activity and a pickup in consumer demand, thereby lifting value stocks. Additionally, the wider spread of vaccinations, new vaccines as well as solid corporate earnings bode well for the value stocks.
Vanguard Value ETF targets the value segment of the broad U.S. stock market and follows the CRSP US Large Cap Value Index. It holds 355 stocks in its basket, with each accounting for less than 2.9% of assets. Vanguard Value ETF has AUM of $94 billion and charges 4 bps in annual fees. The product trades in volume of 4 million shares per day on average and has a Zacks ETF Rank #1 (Strong Buy) with a Medium risk outlook. Short-Duration Bond
Higher rates have been cruel to bond investors, especially the longer-term ones, as an increase in rates have led to rising yields and lower bond prices. This is because price and yields are inversely related to each other and might lead to huge losses for investors who do not hold bonds until maturity. As a result, short-duration bonds are less vulnerable and a better hedge to rising rates.
JPMorgan Ultra-Short Income ETF invests mainly in investment-grade, U.S. dollar-denominated fixed, variable and floating-rate debt. It holds 681 bonds in its basket with an average duration of 0.49 years. JPMorgan Ultra-Short Income ETF has accumulated $18.1 billion in its asset base while trading in a good volume of around 3.3 million shares a day. It charges 18 bps in annual fees. Floating Rate Bonds
Floating rate bonds are investment grade and do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of issuers. Since the coupons of these bonds are adjusted periodically, these are less sensitive to an increase in rates compared to the traditional bonds. Unlike fixed coupon bonds, these do not lose value when the rates go up, making the bonds ideal for protecting investors against capital erosion in a rising rate environment.
iShares Floating Rate Bond ETF follows the Bloomberg Barclays US Floating Rate Note < 5 Years Index and holds 408 securities in its basket. The fund has an average maturity of 1.53 years and an effective duration of 0.07 years. iShares Floating Rate Bond ETF has amassed $7.5 billion in its asset base while trading in a volume of 1.2 million shares per day on average. It charges 15 bps in annual fees.