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The prospect of Fed rate hike and skyrocketing inflation has been pushing yields higher. The 10-year yield is hovering near 1.75% — the highest since March 2021.
The latest Fed minutes revealed policymakers’ concerns about worsening inflation and early interest rate hikes to combat rising inflation. The policymakers signaled three rate increases this year and three in the following year as inflation concerns deepened. The probabilities of a March interest rate hike of 0.25% surged to 72%, according to fed futures trading contracts.
Meanwhile, prices for almost everything, from raw materials to food prices to shipping costs, soared last year at the fastest pace in nearly four decades. This is especially true as the consumer price index jumped 7% year over year in 2021, marking the largest 12-month gain since June 1982. The red-hot inflation has set the stage for the first interest rate hike as soon as in March (read: 5 Most-Loved ETFs to Start 2022).
The initial phase of increase will actually be good for stocks as it will reflect an improving economy. Plus, 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.
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. Further, securities in capital-intensive sectors like telecom would also be impacted by higher rates. Against such a backdrop, investors should be well prepared to protect themselves from higher rates.
Here are a number of strategies that could prove extremely beneficial for ETF investors in a rising rate environment:
Bet on Rate Friendly Sectors
A rising rate environment is highly beneficial for cyclical sectors like financials, industrials and consumer discretionary. Investors seeking protection against rising rates could load up stocks in these sectors. Some of the ETFs having concentrated exposure to the particular sector are Financial Select Sector SPDR Fund XLF, SPDR S&P Homebuilders ETF XHB and Invesco S&P SmallCap Consumer Discretionary ETF PSCD. All these funds have a Zacks ETF Rank #2 (Buy), suggesting their outperformance in the coming months.
Bet on Value
Higher yields indicate investors’ 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 (read: Top-Ranked Value ETFs to Focus on Fed Rate Hike Worries).
While most of the funds in the value space seem excellent choices, Invesco S&P 500 Pure Value ETF RPV and Invesco S&P 500 Enhanced Value ETF SPVU are in green from a year-to-date look. RPV has a Zacks ETF Rank #3 (Hold) and SPVU has a Zacks ETF Rank #1 (Strong Buy).
Hedge Against Interest Rates Rise
Simplify Interest Rate Hedge ETF PFIX seeks to provide a hedge against a sharp increase in long-term interest rates. It buys put options on longer-term Treasury bonds to offer “the most liquid and the most cost-efficient way of getting interest rate protection.” Simplify Interest Rate Hedge ETF is the first ETF providing a simple, direct, and transparent interest rate hedge.
Shorten Bond Duration
Higher rates have been cruel to bond investors, especially the longer-term ones, as an increase in rates 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.
While there are several options in this space, JPMorgan Ultra-Short Income ETF JPST, SPDR Barclays 1-3 Month T-Bill ETF BIL and iShares Short Treasury Bond ETF SHV with durations of 0.49, 0.36 and 0.37 years, respectively, seem intriguing choices (read: Time to Buy Often-Ignored Emerging Market Bond ETFs?).
Focus on 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 the 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.
The most popular ETFs in this space are iShares Floating Rate Bond ETF FLOT, SPDR Barclays Investment Grade Floating Rate ETF FLRN and Market Vectors Investment Grade Floating Rate ETF FLTR.
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Financial Select Sector SPDR ETF (XLF): ETF Research Reports
SPDR S&P Homebuilders ETF (XHB): ETF Research Reports
iShares Short Treasury Bond ETF (SHV): ETF Research Reports
Invesco S&P SmallCap Consumer Discretionary ETF (PSCD): ETF Research Reports
iShares Floating Rate Bond ETF (FLOT): ETF Research Reports
SPDR Bloomberg 13 Month TBill ETF (BIL): ETF Research Reports
VanEck Investment Grade Floating Rate ETF (FLTR): ETF Research Reports
Invesco S&P 500 Pure Value ETF (RPV): ETF Research Reports
SPDR Bloomberg Investment Grade Floating Rate ETF (FLRN): ETF Research Reports
Invesco S&P 500 Enhanced Value ETF (SPVU): ETF Research Reports
JPMorgan UltraShort Income ETF (JPST): ETF Research Reports
Simplify Interest Rate Hedge ETF (PFIX): ETF Research Reports
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