All these issues were discussed in the September meeting itself and the investing world had pushed back the timeline of the lift-off to early next year, presuming a delayed U.S. economic rebound. But to their utter surprise, the Fed kept the December timeline on the table. A keen watch on employment and inflation data is now crucial for the U.S. monetary policy in the December meeting.
After all, the global market turmoil has eased now with the Chinese economy resorting to fresh rate cuts and the ECB hinting at a stepped-up QE measure. The dual dose was sturdy enough to bring the global economy back on the growth path and encourage the Fed to mull over a December hike.
Investors rapidly shifted their bets with futures contracts entailing a 43% December hike possibility compared with 34% preceding the statement. In anticipation of a faster lift-off, the 10-year Treasury bond yields jumped 14 bps to 2.19% in the two days (as of October 29, 2015).
Given this, investors might seek to safeguard themselves from higher rates. For them, we highlight a few investing strategies and the related ETFs:
Say Yes to Zero or Negative Duration Bonds
Rising rates result in increasing losses for bonds since bond price and yields are inversely related to each other. As a result, zero or negative duration bonds are less vulnerable and better hedges to rising rates.
Negative duration bond ETFs offer exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment.
The zero duration funds include WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD) and WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD) while negative duration funds include WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND) (read: Negative Duration Bond ETFs: Right Time to Bet?).
Stick to Floating Rate Bond ETFs
A floating rate note is a bond with a coupon that is indexed to a benchmark interest rate. Some of the popular benchmarks include LIBOR and Treasury rates. Since the coupon is adjusted to reflect market interest rates, at a regular interval, these bonds are less sensitive to increases in rates compared with traditional bonds with fixed rate coupons, which lose value as the rates go up. iShares Floating Rate Note Fund (FLOT) and SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) are some of the floating rate bond ETFs to watch.
Cycle into Cyclical Sectors
Investors should note that rising rates are synonymous with economic improvement. Cyclical sectors like technology and consumer discretionary should perform better ahead. Market Vectors Retail ETF (RTH) and Dynamic Leisure & Entertainment Portfolio (PEJ) are a couple of consumer discretionary ETFs to watch. SPDR S&P Semiconductor ETF (XSD) and PowerShares Nasdaq Internet Portfolio (PNQI) are technology ETFs that investors can try out (read: Top Ranked Retail ETFs Wait for a Holiday Season Rally).
Most importantly, a rising rate scenario is a great backdrop for financial ETFs as this corner of the market should soar on improving interest rate margins. This is because banks borrow money at short-term rates and lend the capital at long-term rates thereby benefitting from a widening spread between long- and short-term rates. Financials ETFs like Financial Select Sector SPDR Fund (XLF) and SPDR S&P Bank ETF (KBE) are some of the financial ETFs to be considered for gains (read: Guide to the 7 Most Popular Financial ETFs).
Withdraw Rate-Sensitive Sectors
There are a few sectors that are highly associated with the Fed’s interest rate policy. Sectors like utilities and real estate are known for their high dividend payout and require huge infrastructure, leading to an immense debt burden and the consequent interest obligation. As a result, these sectors underperform in a rising rate environment. So, investors need to turn aside these sector ETFs or rather bet on inverse utility or real estate ETF to cash in on rising rates.
ProShares UltraShort Utilities ETF (SDP) and ProShares Short Real Estate ETF (REK) are some of the opportunities in this field.
Satiate Income Need with High Yield ETFs
In this backdrop, yield-loving investors might be looking for ways to beat the benchmark Treasury yield and yet enjoy decent capital gains. Senior loan, preferred stock and business development ETFs could fit the bill for high-yield seekers (read: Fight Rising Yield with These High Yield ETFs).
Senior loans are issued by companies with below investment grade credit ratings. In order to make up for this high risk, senior loans normally have higher yields. Since these securities are senior to other forms of debt or equity, senior loans give protection to investors in any event of liquidation. PowerShares Senior Loan ETF (BKLN) and Highland/iBoxx Senior Loan ETF (SNLN) are examples of two senior loan ETFs yielding 3.97% and 4.23% as of October 29, 2015.
Preferred stocks are hybrid securities having characteristics of both debt and equity. The preferred stocks pay the holders a fixed dividend, like bonds. These types of shares normally get priority over equity shares both in case of dividend payments as well as at the time of liquidation if the company fails. Preferred stocks are thus relatively stable and usually exhibit a low correlation with other income-generating assets. iShares S&P U.S. Preferred Stock ETF (PFF) yields about 6.02% as of October 29, 2015.
Business Development Companies (BDCs) are firms that loan out to small- and mid-sized companies at relatively higher rates and often grab debt or equity stakes in those companies.
BDCs dole out high cash payments together with capturing the equity performance of the borrower. The U.S. law obliges BDCs to hand out more than 90% of their annual taxable income to shareholders. Market Vectors BDC Income ETF (BIZD) yields 9.03% as of October 29.
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WISDMTR-B USABN (AGND): ETF Research Reports
WISDMTR-C USABZ (AGZD): ETF Research Reports
ISHARS-FL RT BD (FLOT): ETF Research Reports
MKT VEC-RETAIL (RTH): ETF Research Reports
PWRSH-ND INTRNT (PNQI): ETF Research Reports
SPDR-FINL SELS (XLF): ETF Research Reports
PRO-ULS UTIL (SDP): ETF Research Reports
PWRSH-SNR LN PR (BKLN): ETF Research Reports
ISHARS-US PFD S (PFF): ETF Research Reports
MKT VEC-BDC INC (BIZD): ETF Research Reports
HILND/IBX-SR LN (SNLN): ETF Research Reports
EVEREST RE LTD (RE): Free Stock Analysis Report
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