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Higher interest rates don’t necessarily cause a stock market decline. In fact, some investment types can do quite well when rates are rising.
Yes, as we’ve seen in recent trading days, volatility will increase and stock prices may fall briefly as the old investing mantra, “Don’t fight the Fed,” is evoked. But current concerns over the Fed tightening credit are likely overdone.
History shows that stock prices can move higher another 10% or more in the 12 months surrounding the first Fed rate hike. Therefore, now is a good time to look at ways to profit from rising interest rates.
With that said, there are certain investment types that do better than others in a rising interest rate environment.
Consumer Cyclical Stocks
Consumer cyclical stocks comprise companies that benefit most from discretionary spending of consumers.
Periods of rising interest rates often coincide with strong economic growth. When unemployment is low, wages are relatively high and people have a little more cash to spend on items they don’t necessarily need.
Consumer cyclical stocks include retail firms, media companies, automobile companies, restaurants and companies that sell luxury goods. If you want broad exposure to this sector you can use an ETF, such as Consumer Discretionary Select Sector SPDR (NYSEArca: XLY) or a mutual fund like Fidelity Select Consumer Discretionary (FSCPX).
Financial Sector Stocks
The financial services sector consists primarily of banks, credit card companies, insurance companies and brokerage firms. Examples include Bank of America (NYSE: BAC) and Goldman Sachs (NYSE: GS).
When interest rates are rising, financial companies like banks can charge more for lending. This can increase the spread between lending rates and the rates paid on deposits. Brokerage firms can also benefit when rates are rising, because this environment often coincides with periods of market strength and positive investor sentiment.
One of the best financial sector index funds is Vanguard Financials Index Fund (VFAIX). One of the best ETFs is iShares US Financial Services (NYSEArca: IYF).
Floating-rate Bonds
Also called bank loans, floating rate notes or “floaters,” floating-rate bonds adjust on a regular basis and the respective interest rate is tied to a benchmark, such as the U.S. Treasury bill rate, the LIBOR or the prime rate.
This means that, unlike conventional bonds, floating-rate bonds may also appreciate in value during periods of rising interest rates. But keep in mind that these bond funds can fall significantly in price in declining interest rate environments.
If you want broad access to floating-rate bonds, you can use a mutual fund like Metropolitan West Floating Rate Income Fund (MWFRX) or T. Rowe Price Floating Rate Fund (PRFRX).
Any or all of the above types of investments can work well as satellite holdings around a core, such as an S&P 500 Index fund. For the more risk averse, a small allocation to something liquid, like a money market fund, can be smart because the rate of interest on the fund will likely move higher, along with interest rate hikes from the Fed.
Above all, don’t be afraid of a rising interest rate environment, especially if you are a long-term investor with a diversified portfolio.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
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