An interest rate hike is no longer a question of if but when, and investors need to keep a watchful eye out on any hints in order to stay ahead of the curve. However, the main problem that faces investors even though they are aware of this fact is that there are a number of possible outcomes that could arise from a hike which need to be understood in order to take full advantage of the opportunity.
Conventional wisdom dictates that with an increase in rates, the bull market will most likely see a significant correction while bond yields will move higher and with the Federal Open Market Committee (FOMC) deciding to keep rates unchanged earlier last week, the question on the mind of many investors is how they can play the expected hike.
Before looking into how best investors can play the rate hike, it is important to know that every asset class is exposed to the effects of the fed’s decision.
Far reaching effects
For instance, the market considers government issued bonds to be a safe haven investment since they are not exposed to credit risk and their prices are usually indicative of the current interest rates. This therefore means that when the market expects interest rates to climb, the new bonds issued will have a higher yield and will be more attractive than existing bonds.
On the other hand, stocks particularly dividend paying ones appear to be somewhat shielded from the adverse effects of a rate hike. With bond yields declining, most investors have been making use of dividend payers for income as opposed to high-quality bonds since the amount paid out by the companies is largely determined by the respective boards.
This is in stark contrast to the yield a company pays on its bond which is determined by the market and prevailing yields during issuance.
With the current low interest environment, high yield or junk bonds have enjoyed an unprecedented popularity among investors and according to Bloomberg investors poured in the most money in these bonds in March compared to the past four years amounting to almost $10 billion. This makes plenty of sense considering that the return on junk bonds averaged about 9 percent compared to the S&P 500 which posted returns of 3.1 percent on a year to date basis.
However, as a rate hike in December appears more probable, it seems that a section of investors are getting jittery and are now turning bearish about junk bonds. This begs the question, how can investors leverage the knowledge of the potential rise in interest rate to boost their position?
Junk bonds and long –term treasury bonds are subject to cases of increased volatility which income investors prefer to avoid meaning that they are much better off making use of ETFs that track these kinds of assets as part of a diversified portfolio. Bearing this in mind, here is what investors need to know about some popular ETFs before the rise in interest rates.
4 ETFs to watch ahead of the Fed meeting
Financial Select Sector SPDR (NYSEARCA: XLF) has delivered above average returns to investors averaging 38 percent over the past year. It is widely known that the financial sector is one of the major beneficiaries of interest rate hikes and investors looking to track the performance of the sector will do well investing in XLF. By far, this is one of the most popular financial ETF with an average daily volume of 41 million and more than $16 billion in assets.
The fund is comprised of 95 stocks and its largest exposure is to banks which account for about 34 percent of the weighting and it currently offers a 2.1 percent yield to investors. The fund has shed a couple of points over the past week driven by reports of hedge funds reducing their exposure to German lender Deutsche bank as well disclosures on phantom accounts at Wells Fargo. However, this weakness will most likely be short lived as the market absorbs this news which should give investors a good entry point before the hike.
SPDR Barclays High Yield Bond (NYSE: JNK) has also delivered solid returns on an YTD basis returning 13 percent with an impressive 6.1 percent yield. While a big payout doesn’t mean much to investors if the returns are diminishing, JNK has been able to deliver a 5.4 percent average return over the past five years which is no small feat.
Moreover, things appear to be looking up for the fund as Fitch Ratings announced that it is lowering its 2016 high yield bond default rate forecast to 5 percent from 6 percent and expects 2017 to end with a default rate of just 3 percent, well below the 4.1 percent historical average.
iShares 20+ Year Treasury Bond (NYSEARCA: TLT) is the largest fund that tracks long term treasury prices and has delivered a 14 percent return on year to date basis. The fund’s assets total to about $7.95 billion with a daily average volume of more than 6.4 million shares and it offers a 2.2 percent yield.
According to a number of experts, rising interest rates will have a negative impact on TLT mainly due to the fact that investors have been buying long term bonds priced for zero inflation over the next 50 years. This ultimately means that investors are accepting a level of risk that won’t be compensated by either price appreciation or yield in the long term due to its average weighted maturity of 26.76 years making the fund highly sensitive to interest rate changes.
Furthermore, there are concerns from some that treasuries are currently overvalued. According to Bloomberg, the fair value for the 10-year Treasury yield is 1.95 percent which suggests that benchmark U.S. treasuries yielding 1.56 percent by the end of September are overvalued.
However, investors need to note that since long term yield forecasts have already been trimmed, investors can take advantage of long term Treasury bond ETFs at current levels since there is little likelihood of a rate increase in November.
Consumer Discretionary Select Sector SPDR (NYSEARCA: XLY) also appears to be a great bet for a rising interest rate environment. This is due to the fact that stocks in consumer discretionary usually perform well as the economy improves as illustrated by an improving housing and job market. The fund currently yields 1.5 percent, has $9.97 billion in assets and has an average volume of about 4.63 million shares.
XLY is comprised of 89 shares with specialty retail accounting for 20.2 percent of the fund and media about 23.2 percent. Apart from the fact that the fund is likely to do well in case interest rates rise, a couple of analysts have reaffirmed their positive outlook on the fund and currently believe it has an upside potential of at least 13 percent.