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Guide to Interest Rates Hike and ETFs

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The Federal Reserve has been on an aggressive tightening policy to fight skyrocketing inflation, which is running near its highest levels since the early 1980s. Fed Chair Jerome Powell raised interest rates by another three-quarters of a percentage point in the meeting concluded yesterday. This marks the third consecutive interest-rate hike of 0.75%.

Against 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 - Free Report) , SPDR S&P Regional Banking ETF (KRE - Free Report) , Vanguard Value ETF (VTV - Free Report) , JPMorgan Ultra-Short Income ETF (JPST - Free Report) and iShares Floating Rate Bond ETF (FLOT - Free Report) from different corners of the market seem compelling picks.

The rate hike brings the benchmark interest rate, the federal funds rate, to a 3.0-3.25%, the highest level since 2008, from 2.25-2.5%. The increase in interest rates will make borrowing expensive, driving up the cost of buying a new car or house, or increase the cost of carrying credit card debt and thus slow down economic growth.

The central bank also signaled that additional large rate hikes were likely at the upcoming meetings as it combats inflation that remains near a 40-year high. Fed officials now expect the federal funds rate at a range of 4.25% to 4.5%, a full percentage point above 3.25% to 3.5% to end 2022, projected in June. This suggests the central bank could approve another three-quarter point hike at its November meeting and then a half-point rate rise in December.

Any Reason to Worry?

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 (read: Floating Rate ETFs to Manage Higher Rates).

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. Additionally, securities in capital-intensive sectors like telecom would also be impacted by higher rates. Further, 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 curtail economic growth.

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 51 stocks in its basket, with each firm accounting for no more than 2.3% share. About 44.8% 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 $413.8 million in its asset base and trades in a good average daily volume of about 874,000 shares. The product has an expense ratio of 0.35% and a Zacks ETF Rank #2 (Buy) with 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 help them earn more on lending and pay less on deposits, leading to a wider spread. This will expand net margins and increase banks’ profits.

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 144 stocks in its basket, with each accounting for no more than 2.1% of the assets. SPDR S&P Regional Banking ETF has AUM of $3.2 billion and charges 35 bps in annual fees. It trades in an average daily volume of 5.6 million shares and has a Zacks ETF Rank #1 (Strong Buy) with a High risk outlook (read: Bet on Bank ETFs on Fed Rate Hike).

Value

Higher yields indicate optimism in the economy backed by increased consumer confidence, rising wages and higher spending. This combination of factors will result in increased industrial activity and a pickup in consumer demand, thereby lifting 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 344 stocks in its basket, with each accounting for less than 3% of assets. Vanguard Value ETF has AUM of $98.2 billion and charges 4 bps in annual fees. The product trades in a volume of 2.2 million shares per day on average and has a Zacks ETF Rank #1 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 has 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 (read: Time to Buy Cash-Like ETFs?).

JPMorgan Ultra-Short Income ETF invests primarily in a diversified portfolio of short-term, investment grade fixed-and floating-rate corporate and structured debt while actively managing credit and duration exposure. It holds 620 bonds in its basket with an average duration of 0.29 years. JPMorgan Ultra-Short Income ETF has accumulated $21.8 billion in its asset base while trading in a good volume of around 4 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 399 securities in its basket. The fund has an average maturity of 1.70 years and an effective duration of 0.08 years. iShares Floating Rate Bond ETF has amassed $9.3 billion in its asset base while trading in a volume of 1.3 million shares per day on average. It charges 15 bps in annual fees.