Guide to rising interest rates and ETFs – September 22, 2022
The Federal Reserve has pursued an aggressive tightening policy to combat soaring inflation, which is near its highest levels since the early 1980s. Fed Chairman Jerome Powell raised inflation interest rate by an additional three-quarters of a percentage point at the meeting concluded yesterday. This is the third consecutive increase in interest rates of 0.75%.
In this context, investors must be well prepared to protect themselves from a rise in rates. While there are a 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 ETFs (KRE – free report), Vanguard Value ETFs (VTV – free report), JPMorgan Ultra-Short Income ETF (JPST – free report) and iShares Floating Rate Bond ETF (FLOW – Free report) from different corners of the market seem compelling choices.
The rate hike takes the benchmark interest rate, the federal funds rate, to 3.0-3.25%, the highest level since 2008, from 2.25 to 2.5%. Rising interest rates will make borrowing expensive, driving up the cost of buying a new car or house, or increasing the cost of credit card debt and thus slowing economic growth.
The central bank also signaled that more big rate hikes were likely in upcoming meetings as it battles inflation that remains near a 40-year high. Fed officials now expect the fed funds rate to be in the range of 4.25% to 4.5%, a full percentage point above 3.25% to 3.5 % until the end of 2022, expected in June. That suggests the central bank could approve another three-quarter point hike at its November meeting and then a half-point rate hike in December.
A reason to worry?
Higher rates would attract more capital into the country, boosting the US dollar against the basket of other currencies. However, since a strong dollar is expected to have a huge impact on commodity-related investments, a rising rate environment will also affect 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 hardest hit given their greater sensitivity to rising interest rates. In addition, securities in capital-intensive sectors such as telecommunications would also be affected by higher rates. Additionally, rising interest rates will make borrowing expensive, driving up the cost of buying a new car or house, or carrying credit card debt and thus stunting economic growth.
Insurance stocks are one of the biggest beneficiaries of rising rates, as they are able to earn higher yields on their investment portfolio of longer-duration bonds. But at the same time, these companies suffer losses when the value of longer-term bonds declines with rising interest rates. However, since insurance companies have long-term investment horizons, they can hold investments until maturity and therefore no real loss will be realized.
The SPDR S&P Insurance ETF tracks the S&P Insurance Select Industry Index, holding 51 stocks in its basket, with each company representing no more than 2.3% share. About 44.8% of the portfolio is allocated to property and casualty insurance, while life and health insurance and insurance brokers round out 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 healthy average daily volume of around 874,000 shares. The product has an expense ratio of 0.35% and a rank #2 (buy) Zacks ETF with a medium risk outlook.
As banks seek to borrow money at short-term rates and lend at long-term rates, rising interest rates will help them earn more on loans and pay less on deposits, which will cause a wider gap. This will increase net margins and increase bank profits.
The SPDR S&P Regional Banking ETF provides exposure to the regional banking segment by tracking the S&P Regional Banks Select Industry Index. He has 144 stocks in his basket, each representing no more than 2.1% of assets. The SPDR S&P Regional Banking ETF has assets under management of $3.2 billion and charges 35 basis points 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: Betting Bank ETFs on Fed Rate Hike ).
Higher yields indicate optimism in the economy supported by increased consumer confidence, rising wages and higher spending. This combination of factors will result in increased industrial activity and a recovery in consumer demand, thereby increasing value stocks.
Vanguard Value ETF targets the value segment of the broad US stock market and tracks the CRSP US Large Cap Value Index. He has 344 stocks in his basket, each representing less than 3% of assets. Vanguard Value ETF has an AUM of $98.2 billion and charges 4 basis points in annual fees. The product trades in a volume of 2.2 million shares per day on average and has a Zacks ETF #1 rating with a medium risk outlook.
Short term bond
Higher rates have been cruel to bond investors, especially longer term ones, as a rise in rates has led to higher yields and lower bond prices. This is because price and yields are inversely related and can result in huge losses for investors who do not hold bonds to maturity. As a result, short-dated bonds are less vulnerable and a better hedge against rising rates (read: Time to buy cash ETFs?).
JPMorgan Ultra-Short Income ETF invests primarily in a diversified portfolio of high quality short-term, fixed and floating rate corporate and structured debt, while actively managing credit and duration exposure. He holds 620 bonds in his 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 a good volume of around 4 million shares per day. It charges 18 basis points in annual fees.
Floating rate bonds
Floating rate notes are investment grade and do not pay a fixed rate to investors, but have variable coupon rates that are often linked to an underlying index (such as LIBOR) plus a variable spread based on risk credit from issuers. The coupons of these bonds being adjusted periodically, they are less sensitive to a rise in rates compared to traditional bonds. Unlike fixed coupon bonds, these do not lose value when rates rise, making them ideal bonds to protect investors against capital erosion in a rising rate environment.
iShares Floating Rate Bond ETF tracks the Bloomberg Barclays US Floating Rate Note
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