Yahoo Finance Investors Can Benefit from Rising Interest Rates
Rising interest rates may not be optimal for everyone, but it could mean above-average performance for financial sector investors this year, making the asset class a worthy component of a balanced portfolio.
Banks make their money on the difference between the interest rate they charge to borrowers and the yield paid to depositors and savers, says John Anagnos, managing principal of Aetolia Capital in Greenville, Delaware. When rates rise, this spread gets wider, resulting in an immediate increase to their bottom lines, especially larger institutions like JPMorgan Chase & Co. (NYSE: JPM), Citigroup ( C), and Bank of America Corp. ( BAC).
But when interest rates go up or when the Federal Reserve raises rates, short-term notes used by banks and financial institutions to invest cash also increase, which results in a higher return on cash holdings. Tax reform will also play a role in boosting the banks, as corporate and individual tax rates decline, spurring spending.
And while most Americans likely won't be happy that mortgage and credit card interest rates will go up, financial sector investors are staying happy. Just take a look at the share prices of a few of the nation's largest banks: Bank of America shares are up to about $30.50 from about $22 a year ago. Citi is trading at about $76 from $58 a year ago.
[See: 7 of the Best Bank Stocks to Buy for 2018.]
And for a diligent and savvy investor this year, financial stocks can be a good hedge against other sectors that do poorly when interest rates go up, says Joel Salomon, a former hedge fund manager and founder of SaLaurMor Management. That's because companies will have to pay more for their debt and don't necessarily earn more income. Salomon recommends "overweighting" the financial sector up to about 30 percent of a portfolio in the next one to two years (financial stocks currently represent about 18 to 22 percent of major indices such as the Standard & Poor's 500 index, he says).
As with any security, investments in the financial sector require vigilance and scrutiny, so heed the following tips from the experts before buying in.
Select stocks carefully. Treat an individual financial stock the same way you would at any other industry or sector, looking at return on equity, earnings growth, price-earnings ratio, the management team, cash reserves and loan and credit performance during previous tough times, Salomon says. You'll want to see that the institution can weather another downturn.
Salomon likes American Equity Investment Life Holding Co. ( AEL), an annuity insurance company that benefits from higher long-term interest rates since it invests mostly in bonds and earns money by the spread between the earned rate on their assets and the crediting rate to their annuity policies. Credit card company Discover Financial Services ( DFS) should benefit from interest rate increases, he says.
Track the sector broadly. If you're not willing or able to perform extensive due diligence on individual opportunities, it's best to stick to index funds or exchange-traded funds that track the entire sector, says Andy Yadro, an investment advisor with Googins Advisors in Madison, Wisconsin.
[See: 7 ETFs to Trade Like a Hedge Fund.]
"You can still pick up on most potential upside, but you will diversify away from company specific risk," Yadro says. "It's far too time consuming for the average investor to perform the due diligence necessary to make an educated stock pick."
-- The Davis Select Financial ETF (DFNL), for example, is trading at about $24.81 a share, up from about $20 last year. This fund has an average expense ratio of 0.55 percent, or $55 per $10,000 annually invested.
-- Financial Select Sector SPDR ETF (XLF) is trading at about $29.27, up from about $23 a year ago. Its expense ratio is 0.04 percent.
-- Vanguard Financials ETF (VFH) is trading at $73.19 from about $59 a year ago. This ETF has an expense ratio of 0.09 percent.
Holdings in these funds include heavy hitters such as JPMorgan Chase, Bank of America, Wells Fargo & Co. ( WFC), Goldman Sachs Group ( GS), Chubb Ltd ( CB) and, Berkshire Hathaway ( BRK.A, BRK.B).
Keep a global outlook. Larger financial institutions will also take advantage of more wealth growing in places across the world and in emerging markets, such as in Asia, Anagnos says.
This leads to more assets under the banks' tutelage, which means more fee and revenue generation. And just as more people and companies in emerging markets will need to borrow and deposit money, they'll also need someone to manage their wealth. Wealth management firms are likely to see this benefit directly and relatively quickly, Anagnos says.
Such firms have also focused on placing new assets "in a fee-based structure so they will benefit from this momentum-driven stock market," which means they will cash in as the markets climb, he says.
[See: 10 Investing Themes to Remember for 2018.]
You'll also likely see at least a few significant mergers and acquisitions among U.S regional banks, Anagnos says. But pump the brakes when examining European banks, since they are still in the middle of a cautious ascent.
"This will also provide some opportunities," Anagnos says.
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