Back to top

Image: Bigstock

ETF Areas to Consider as Fed Hikes Rates Again in 2022

Read MoreHide Full Article

Investors are struggling with rising Treasury yields and the Fed’s aggressive stance on interest rate hikes to control inflation levels. Strongly reversing a rally observed since May beginning, Wall Street ended May 5 with all major averages in the red. The Dow Jones Industrial Average declined 3.1% on the same day. The other two broad market indices, the S&P 500 and the Nasdaq Composite, were also down 3.6% and 4.9%, respectively, in yesterday’s trading session.

The benchmark 10-year Treasury note yield surged to nearly 3.04% in afternoon trading on May 5, touching the highest mark since 2018. The 30-year Treasury bond yield also increased to roughly 3.126%.

The central bank hiked the benchmark interest rates by 50 basis points on May 4, in line with market projections. Notably, the hike highlights the biggest interest-rate increase since 2000. Suppressing investor projections of a 75-basis-point hike, the Fed has indicated that it plans to keep the pace same for rate hikes over the next couple of meetings.

The central bank also plans to start reducing its huge $9-trillion balance sheet, comprising primarily of Treasury and mortgage bonds, from June this year. It aims to begin with an initial combined monthly pace of $47.5 billion ($30 billion in Treasuries and $17.5 billion in mortgage-backed securities). That pace of reduction will remain from June through August until September, when the Fed will raise that cap up to $95 billion ($60 billion in Treasuries and $35 billion in mortgage-backed securities).

Commenting on the market conditions, Zachary Hill, head of the portfolio strategy at Horizon Investments, noted that “Despite the tightening that we have seen in financial conditions over the last few months, it is clear that the Fed would like to see them tighten further. Higher equity valuations are incompatible with that desire, so unless supply chains heal rapidly or workers flood back into the labor force, any equity rallies are likely on borrowed time as Fed messaging becomes more hawkish once again,” according to a CNBC article.

Against this backdrop, let’s take a look at some ETF areas that might look attractive and gain investor attention:

Banking ETFs

The shift toward a tighter monetary policy will push yields higher, thereby helping the financial sector. This is because rising rates will help in boosting profits for banks, insurance companies, discount brokerage firms and asset managers. The steepening of the yield curve (the difference between short and long-term interest rates) is likely to support banks’ net interest margins. As a result, net interest income, which constitutes a chunk of banks’ revenues, is likely to receive support from the steepening of the yield curve and a modest rise in loan demand. Notably, as the economy starts operating in full swing, the banking space will be able to generate more business.

Let’s take a look at some banking ETFs that can gain from the current environment: First Trust Nasdaq Bank ETF (FTXO - Free Report) , Invesco KBW Bank ETF (KBWB - Free Report) , Invesco KBW Regional Banking ETF (KBWR - Free Report) , iShares U.S. Regional Banks ETF (IAT) and SPDR S&P Regional Banking ETF (KRE) (read: ETF Areas in the Spotlight Post Buffett's 2022 Meeting).

Insurance ETFs

The insurance industry makes up a considerable size of the financial sector. A reduction in bond buying can push bond prices down. This may increase the yield to maturity of bonds. Higher bond yields might raise the market's risk-free returns. A risk-free market interest rate hike can raise the cost of funds, enabling financial companies to widen the spread between longer-term assets, such as loans, with shorter-term liabilities, thus boosting the financial sector’s profit margin.

Insurance providers are generally compelled to hold several long-term safe bonds to back the policies written. A higher interest rate will benefit insurance companies. The spread between the longer-term assets and shorter-term liabilities will increase the spread of insurers. Moreover, the insurance industry's profitability has risen historically during the period of rising interest rates. SPDR S&P Insurance ETF (KIE - Free Report) and iShares U.S. Insurance ETF (IAK) are good options for investors to consider.

Floating Rate ETFs

Floating rate bonds are investment grade in nature and are not supposed to pay a fixed rate to investors. Instead, they have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread and are determined based on the credit risk of the issuers.

Since the coupons of these bonds are adjusted periodically, these are less sensitive to rising rates than 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.

Amid the current war scenario, the high chances of the Federal Reserve hiking the benchmark interest rates have raised the appeal of floating-rate bonds. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates than traditional bonds. Against this backdrop, investors can consider ETFs like iShares Treasury Floating Rate Bond ETF (TFLO - Free Report) , iShares Floating Rate Bond ETF (FLOT - Free Report) and VanEck Investment Grade Floating Rate ETF (FLTR).