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Which Investments Could Benefit From Rising Interest Rates?

Bank loans and financials stocks could rise if rates do, but interested investors should be careful not to overpay.

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Ahead of the Fed’s rate decision later today, we’re refeaturing this research article from 2014 on how investors’ portfolios have fared in rising rate environments. 

"Interest Rates Have Nowhere to Go but Up" 

"Rising Rates Threaten the Value of Bond Holdings" 

"Are You Ready for Rising Interest Rates?" 

With the Federal Reserve likely to start hiking interest rates later this year, those headlines wouldn't be out of place on home pages and newspaper front pages today. 

The trouble is that they were drawn from articles published back in 2010. In the intervening five years, the yield on the 10-year Treasury has dropped nearly in half, from 3.6% in early March 2010 to less than 1.7% earlier this year. (Treasury yields have begun popping up in recent weeks.) 

Clearly, even "smart money" can be wrong, and for a long time. Investors who steered a percentage of their bond money to short-term bonds or cash to protect themselves against rising rates have experienced an opportunity cost: The average short-term bond fund has gained about 2% on an annualized basis over the past five years, whereas the typical intermediate-term bond fund has returned double that amount. 

Meanwhile, investors who took dramatic action to actually profit from rising rates have gotten hurt far worse. A spate of mutual funds and exchange-traded funds were launched in the late 2000s. Many such products were set up to short bonds and deliver positive returns even as bonds entered their expected "death spiral," but their arrival was ill-timed. The typical fund in Morningstar's Trading Inverse Debt category has posted an annualized loss of 13.5% over the past five years through early March. Investors who magnified their bet against bonds by buying funds that employ leverage fared even worse: For example, Direxion Daily 20+ Year Treasury Bear 3X ETF (TMV) has lost more than 38% on an annualized basis over the past five years. 

Picking Your Spots
That's a good illustration of how maintaining a diversified portfolio and basing your investment mix on your anticipated time horizon is invariably a better course of action than positioning your portfolio to benefit from macroeconomic events that may or may not pan out. That said, the Fed is apt to tighten up rates eventually--whether that happens at midyear or later this year is the real wild card. Given that, it's not unreasonable for opportunistic investors to take a look at asset types that would hold up reasonably well--or even benefit--in a rising-interest-rate environment, even as they maintain their asset-allocation targets. 

Of course, the possibility of rising rates has been around for a while, so some of the likely benefits of rising rates may already be priced into some of these securities. Here's an overview of the case for some of those categories--as well as what could go wrong--followed by a discussion of some of the top picks within each. 

Bank-Loan/Floating-Rate Funds
The Bull Case: Bank loans--or floating-rate loans--behave differently from most other bond types. Conventional bonds have fixed interest rates, and that means they'll tend to lose value when prevailing bond yields rise; the presence of new bonds with higher yields decreases demand for the older, lower-yielding bonds. By contrast, the interest rates on bank, or floating-rate, loans adjust on a regular basis to keep pace with short-term interest rates. That means that when bond yields go up, bank-loan owners receive a higher yield--not immediately, but eventually. For that reason, bank-loan securities may also appreciate in value during periods of rising interest rates. Moreover, considering that interest rates often increase in periods of economic strength, bank loans may also appreciate during a rising-rate period because investors assume that there's less of a risk that the companies borrowing via the bank-loan market will have trouble meeting their obligations. Finally, investors have been pulling assets from bank-loan funds over the past year, to the tune of $21 billion in outflows in the one-year period through December 2014. The fact that other investors have been leaving doesn't automatically mean that there's no froth in the sector, but big outflows from a given category can be a contrarian indicator. 

What Could Go Wrong: Bank loans face risks under a few different scenarios. One is what we've experienced recently: When interest rates decline, the returns from bank-loan funds will be meager alongside investments with greater interest-rate sensitivity. As intermediate- and longer-term bonds have rallied on interest-rate declines over the past year, bank-loan funds have done just a little better than stand still, gaining only 1.6%, on average, versus a nearly 5% return for the Barclays U.S. Aggregate Bond Index. Perhaps the bigger concern with bank-loan funds, however, is if the economy were to weaken unexpectedly. Because many bank-loan borrowers have low credit qualities, they're at greater risk of default in a weakening economic environment. The typical bank-loan fund lost 30% of its value in 2008's financial crisis, for example. Given their junky credit profiles, bank loans aren't likely to provide as much diversification in an equity-market sell-off as high-quality bonds would. 

Top Picks: Morningstar has several highly rated picks in the bank-loan category.  Eaton Vance Floating Rate (EIBLX) and  Eaton Vance Floating-Rate Advantage (EIFAX) are the two Silver-rated options; the former tends to be more conservative than the latter. Both funds may carry sales charges, depending on sales channel.  Fidelity Floating Rate High Income (FFRHX) and  RidgeWorth Seix Floating Rate High Income (SAMBX) are both no-load funds that earn Bronze ratings. The Fidelity fund saw a management change in 2013, but it retains a sensible, conservative-leaning portfolio. Meanwhile, the RidgeWorth fund benefits from a deep team, an emphasis on quality and liquidity, and even lower expenses. 

Financials Stocks
The Bull Case: Equities won't necessarily decline in periods of rising interest rates--this article includes a thorough review of the historical data--and some may even benefit. Morningstar StockInvestor editor Matt Coffina notes that all manner of cyclical firms tend to perform well in periods of rising interest rates, because such periods often coincide with strong economic growth. But financial companies are usually considered the most direct beneficiaries of rising rates. Banks are perhaps the most obvious example, in that higher interest rates mean they can charge more for lending, thereby increasing the spread between lending rates and the rates they must pay on deposits. Insurers, too, can benefit during rising-rate periods, in that they can earn higher returns on the premiums they take in. Brokerage firms and asset managers may also tend to benefit during rising-rate environments, because rising rates often coincide with periods of market strength and investor enthusiasm. 

What Could Go Wrong: Valuations are perhaps the biggest risk to today's purchasers of financial stocks or any other company that stands to benefit from rising interest rates. The probability that rates will rise has been well known in the market for some time, and the typical financial stock in Morningstar's coverage universe is 1.0. That means the companies aren't especially cheap today, and some pockets of the sector--including reinsurance and financial exchanges--look notably overvalued. Both Coffina and Morningstar DividendInvestor editor Josh Peters agree that many of the companies that would stand to benefit from a period of rising rates are picked over, if not downright expensive. Peters points to  Wells Fargo (WFC) and payroll processor  Paychex (PAYX) as two firms that he likes that are also leveraged to the interest-rate cycle, but he considers them overpriced. "Valuation trumps any macro prediction in my book," he said. 

Top Picks: Coffina considers  Bank of America (BAC) to be a rare firm that's both leveraged to the interest-rate cycle and reasonably valued today; as of March 3, it was trading a bit below senior equity analyst Jim Sinegal's $18 fair value estimate. Coffina says he's also keeping his eye on firms that could be negatively affected in a rising-rate environment, because he thinks there could eventually be buying opportunities there. Although REITs and utilities are currently overvalued, in his view, he has them on his watchlist because he suspects that the market could overreact when rates begin to trend up. They've struggled a bit recently, but Coffina thinks they have further to fall before their valuations are attractive.

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.