While interest rates are currently at historic lows, experts predict an inevitable upswing to occur sometime later this year. And while the exact timetable is subject to debate, one thing is certain: surging rates demand careful attention when crafting an investment portfolio. This includes bolstering positions in short- and medium-term bonds, which are less sensitive to climbing rates, as well implementing a “bond ladder” to maximize cash and debt returns. (For more on this topic, see How To Protect Yourself From Rising Interest Rates). But a rising-rate environment also offers tantalizing opportunities within the equity space. A good starting point it examining the right sectors – ones that tend to benefit from rising rates.
Boasting margins that actually expand as rates climb, financial entities like banks, insurance companies, brokerage firms and money managers tend to be good bets.
Rising rates tend to point to a strengthening economy. And that health usually means that borrowers have an easier time making loan payments and banks have fewer non-performing assets. It also means that banks can earn more from the spread between what they pay savers for savings accounts and certificates of deposit and what they can earn from highly-rated debt – Treasuries, for example.
Bank names that would fit nicely into any portfolio as rates rise include Bank of America Corp. (BAC), which has a substantial presence throughout the U.S.; JPMorgan Chase & Co. (JPM), with its robust operations in the U.S. and worldwide; Goldman Sachs Group Inc. (GS), with widespread investment banking and wealth management services; and Citigroup Inc. (C), which boasts more than 200 million customer accounts and does business in more than 160 countries. Bank of America, among the hardest-hit in the recession, saw its charge-offs drop by 49% in the fourth quarter of 2013 year over year. All banks should benefit from falling charge-offs, better credit ratios and lower loan loss reserves.
On the broker front, companies like E*TRADE Financial Corp. (ETFC), Charles Schwab Corp. (SCHW), and TD Ameritrade Holding Corp. (AMTD), all hold promise during times of escalating rates for similar reasons. A healthy economy sees more investment activity.
Insurance stocks, especially, tend to flourish as rates rise. In fact, the relationship between interest rates and insurance companies is linear and straightforward, meaning the higher the rate, the greater the growth. These same insurance providers – companies such as The Allstate Corp. (ALL), AmTrust Financial Services, Inc. (AFSI), and The Travelers Companies, Inc. (TRV), don’t fare as well in low interest rate climates because their underlying bond investments yield weak returns. Insurers, which have steady cash flows, are compelled to hold lots of safe debt to back the insurance policies they write.
The economic health dividend also applies to insurers; improving consumer sentiment means more car purchasing and improving home sales, which means more policy-writing.
Financials aren’t the only star performers in a rising rate environment; consumer discretionary stocks also can see a bump. Improving employment, coupled with a healthier housing market, makes consumers morel likely to splurge on purchases outside of the realm of consumer staples (food, beverages and hygiene goods). Manufacturers and sellers of kitchen appliances, cars, clothes, hotels, restaurants, movies and more benefit from the economic health dividend. Companies to keep an eye on include appliance maker Whirlpool Corp. (WHR), retailers Kohl's Corp. (KSS), Costco Wholesale Corp. (COST) and Home Depot, Inc. (HD), and travel facilitators like The Priceline Group Inc. (PCLN).
Finally, the industrials sector also benefits from the economic health dividend indicted by rising rates. Companies like Ingersoll-Rand PLC (IR) and manufacturers of heating, ventilation, and air conditioning (HVAC) systems, tend to outperform, as well as companies like PACCAR Inc. (PCAR), – a maker of heavy-duty trucks and truck parts. Such companies are among the first to benefit from any increase in housing starts.
The Bottom Line
You've adjusted your fixed income portfolio to account for rising rates. Now is the time to adjust your equity investments to favor companies that benefit from the economic health dividend indicated by rising rates. An excellent place to start is the financials sector. From there – as consumer confidence picks up and housing follows suit – consider durable-goods manufacturers, retailers, travel-related stocks and the industrials sector.